Buffett beyond value

E1FFIRS

Date:Jan19,2010

Time:10:56am

E1FFIRS

Date:Jan19,2010

Time:10:56am

Buffett

BeyondValue

E1FFIRS

Date:Jan19,2010

Time:10:56am

E1FFIRS

Date:Jan19,2010

Time:10:56am

Buffett

BeyondValue

WhyWarrenBuffettLooksto

GrowthandManagement

WhenInvesting

PremC.Jain

JohnWiley&Sons,Inc.

E1FFIRS

Date:Jan19,2010

Time:10:56am

PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey.

PublishedsimultaneouslyinCanada.

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LibraryofCongress

Cataloging-in-PublicationData:

Jain,PremC.1950–

Buffettbeyondvalue:whyWarrenBuffettlookstogrowthandmanagementwheninvesting/PremC.Jain.

Includesbibliographicalreferencesandindex.

ISBN978-0-470-46715-2(cloth)

Investments.2.

Investmentanalysis.3.

Buffett,Warren.I.

Title.

HG4521.J2642010

332.6–dc22

2009041474

PrintedintheUnitedStatesofAmerica

10987654321

E1FTOC

Date:Feb4,2010

Time:2:24pm

Contents

Preface

Acknowledgments

PartOne

IntroductionandBackground

Chapter1

TheThrillofInvestinginCommonStocks

Chapter2

1965–2009:LessonsfromSignificantEventsin

BerkshireHistory

PartTwo

BuffettInvesting=Value+Growth

Chapter3

ValueInvesting—It’sLike

BuyingChristmas

CardsinJanuary

Chapter4

GrowthInvesting

Chapter5

IntrinsicValue

Chapter6

E1FTOC

Date:Feb4,2010

Time:2:24pm

contents

PartThree

OtherPeople’sMoney

Chapter7

Insurance:OtherPeople’sMoney

Chapter8

Reinsurance:MoreofOtherPeople’sMoney

Chapter9

TaxDeferment:Interest-FreeLoansfrom

theGovernment

PartFour

SuccessinRetailing,Manufacturing,

andUtilities

Chapter10

IfYouDon’tKnowJewelry,KnowYourJeweler

Chapter11

CompeteLikeMrs.B

Chapter12

WhyInvestinUtilityCompanies?

Chapter13

HighProfitsinHonest-to-Goodness

ManufacturingCompanies

PartFive

Risk,Diversification,andWhentoSell

Chapter14

RiskandVolatility:HowtoThinkProfitably

aboutThem

Chapter15

WhyHoldCash:LiquidityBringsOpportunities

Chapter16

Diversification:HowMany

BasketsShould

YouHold?

Chapter17

WhentoSell

PartSix

MarketEfficiency

Chapter18

HowEfficientIstheStockMarket?

Chapter19

ArbitrageandHedgeFunds

E1FTOC

Date:Feb4,2010

Time:2:24pm

Contents

PartSeven

Profitabilityand

Accounting

Chapter20

M=Monopoly=Money

Chapter21

WhoWinsinHighlyCompetitiveIndustries?

Chapter22

Property,Plant,andEquipment:GoodorBad?

Chapter23

KeytoSuccess:ROEandOtherRatios

Chapter24

AccountingGoodwill:IsItAnyGood?

PartEight

Psychology

Chapter25

HowMuchPsychologyShouldYouKnow?

Chapter26

HowtoLearnfromMistakes

PartNine

CorporateGovernance

Chapter27

Dividends:DoTheyMakeSenseinThisDay

andAge?

Chapter28

ShouldYouInvestinCompaniesThat

RepurchaseTheirOwnShares?

Chapter29

CorporateGovernance:Employees,Directors,

andCEOs

Chapter30

LargeShareholders:TheyAreYourFriends

Conclusion

B=Baseball=Buffett

Appendix

ASummaryoftheBook

AbouttheAuthor

E1FTOC

Date:Feb4,2010

Time:2:24pm

E1FPREF

Date:Jan19,2010

Time:11:46am

Preface

Thisbookisforeveryonewithaseriousinterestinlearningabout

stockmarketinvestingusingprinciplesespousedbyWarren

Buffett.Justover20yearsago,whileteachingattheWharton

School,IstumbleduponanessaybyWarrenBuffettthat

motivatedme

tocarefullyinvestigatehisinvestmentstyle.1IwasintriguedwhenIrealizedthattherewasafundamentaldifferencebetweenBuffett’sattitude

towardinvestingandtheacademicapproach.Whileacademicsgenerally

anchorontheimpossibility

ofmakingabove-averagereturns,Buffett

proposesjusttheopposite.Hearguesthatwithacarefulstudyofcompanyfundamentalsandmanagementquality,investorsdefinitivelycanearn

above-averagereturns.Hisoutstandinglong-termrecordsupportshis

claim.WhenfacedwithBuffett’srecord,mostacademicseitherdismiss

itasanoutlierorbrandhimageniuswhocannotbecopiedorexplained.

Iwantedtoknowiftherewasasystematicwayofunderstandingand

emulatinghisinvestmentphilosophy.

Mostauthors,includingacademics,characterizeBuffettasavalue

investor.Buffettisnotjustavalueinvestor—atleastnotinthepopularsensethatthe“value”monikerisused.Buffett’spubliclytradedcompany,BerkshireHathaway,hasgrownatanannualizedrateofabout20percent

inassets,revenues,networth,andmarketvaluefor44years.Hisper-

formanceisclosertowhatwouldbeexpectedfromasuccessfulgrowth

investor.Unlikeotherbusinessmenwhomayhavealsoamassedgreatfor-

tunes,Buffettstandsalonebecausehislong-term

successreflectsgrowth

E1FPREF

Date:Jan19,2010

Time:11:46am

preface

ofhisbusinessand

investmentsinseveraldifferentindustrieswithouteverridingahottrend.ThereisanothermajordifferencebetweenBuffett

andothersuccessfulinvestors,whichisactuallythemainreasonIchose

tostudyhimdiligently.WarrenBuffettisamanofthehighestlevelof

integrity.Heknowsthathehasaspecialgift,andinsteadofkeepingittohimself,hehaschosentosharehisimmenselyvaluableexperienceswith

anyonewhocarestodosomeresearch.Aremarkableteacher,Buffett

haswrittenaconsiderablebodyofmaterialonhisideasandprinciples,

whichallowsforcarefulexaminationofhisstrategiesandmotivations.

ThekeyreasonforBuffett’sunparalleledsuccessisnotonlyhisability

tostayresolutewiththeprimaryvalueinvestingprincipleofmaintain-

ingalowdownsideriskbutalsohisskillatpairingit

withthegrowth

investingprincipleofputtingmoneyintocompanieswithsustainable

growthopportunities.Thus,hecombinestheprinciplesofboththe

valueandgrowthinvestmentstrategies.Yet,hedoesnotinvestinhigh-

techcompanies,assomanygrowthinvestorsdo.Hisgrowthstrategyis

bestunderstoodbystudyingthebusinesseshehaspurchasedatBerkshire

Hathaway.Buffettbuysgoodbusinessesthatalreadypossessoutstand-

ing,high-integritymanagement.Hereliesonthe

sameprinciplesfor

investingincommonstocks.Ielaborateonhisinvestmentprinciples

throughoutthebookalongwiththespecifictopicscoveredineachchap-

ter.Theseprinciplesareusefulwhetheryouareinvestinginabullmarketorabearmarket.

BuffettandContemporaryTeachingsat

BusinessSchools

Mygoalasateacher-researcherisnotonlytoexplorewhatBuffett

practicesbutalsotofindanswerstowhyhispracticesaresuccessful.

In1997,mydesireto

understandwhyBuffett’sinvestmentstyleworksandhowhisstrategiesblendwiththelessonsfromcontemporaryfinanceledmetodevelopanewcourseatTulaneUniversity.Thiscoursetooka

newapproachtofinance,wherestudentsstudiedBuffett’swritingsand

decisionsinconjunctionwith

modernfinanceresearch.Thestudents

alsoanalyzedalargenumberofbusinesses.In1999,Tulanecontributed

$2millionfromtheuniversity’sendowmentfundtocreateaportfolio

E1FPREF

Date:Jan19,2010

Time:11:46am

Preface

tobemanagedbystudentsundermyguidance.IleftTulanein2002for

GeorgetownUniversity,butProfessorSheriTicecontinuestoteachthe

increasinglypopularcourseatTulane.

Fromtheoutset,itisimportanttorecognizethatBuffett’sideasare

notalwaysatoddswithmodernfinancetheories.Forexample,thecon-

ceptsofdiscountingcashflowsandnetpresentvaluearetaughtinall

businessschools.Resemblingthenetpresentvalueconcept,concepts

likeintrinsicvalueandmarginofsafetyareatthecoreofBuffett-styleinvesting.Furthermore,themuch-talked-aboutconceptofdiversificationisdiscussedinasomewhatsimilar,althoughnotidentical,fashion

bothbyinvestmenttextsandbyBuffett.Thereisplentyofcommonality

betweenthebusinessschoolcurriculumandBuffett’sapproach.How-

ever,thisbookcoversideasfromBuffettthatgobeyondwhatprofessors

generallyoffer.Mygoalistoprovideadditionalinsightsto

leadyou

towardamorepracticalapproachtoinvestinginthestockmarket.

FocusonImportantQuestions

OnekeytraitthatmakesBuffettsuccessfulishisabilitytofocus.To

remainfocused,Ipresent

manysectionsofthebookinaquestion-

and-answerformat.ThisSocraticstyleforcesonetopinpointimportant

questionsthatfellowinvestors,students,andcolleagueshaveaskedme

overtheyears.AtBerkshireHathawayannualmeetings,manyofwhich

Ihaveattendedoverthepast20years,WarrenBuffettandCharlie

Munger(chairmanandvicechairmanofBerkshireHathaway,respec-

tively)answerquestionsfromtheaudienceforseveralhours.Buffett

alsousedaquestion-and-answerformatin2003when

heaccepted

myinvitationtoaddressGeorgetownUniversityMBAstudentsand

faculty.

AlthoughthisbookconcentratesonBuffett’sinvestingstyle,Ibring

inrelatedideasfromotherinvestorsandacademic

researchtohelp

improveyourinvestmentstrategies.Forexample,nodiscussiononinvest-

ingiscompletewithoutincorporatingthepioneeringandstillrelevant

worksofBenjaminGrahamandDavidDodd.Similarly,Idrawfromthe

thoughtsofPhilipFisherandPeterLynchtodiscussgrowthinvesting

strategies.

E1FPREF

Date:Jan19,2010

Time:11:46am

preface

NoonecanteachBuffett’sideasbetterthanBuffetthimself.Clearly,

heknowsathingortwoaboutinvesting.InMarch2008,ForbesmagazinerankedBuffettastheworld’swealthiestmanwithanestimatedpersonal

wealthof$62billion.2I

wrotehimaletterin1997suggestingthatfuturegenerationswouldthankhimifheweretowriteabook.Heresponded,

“Idefinitelyhaveabookinmind,thoughmuchofwhatIhavetosayhas

beencoveredintheannualreports.”WhilewewaitforBuffetttowrite

hisinvestmentbook,Idecidedtosharemyownanalyses.Tounmaskhis

thoughts,IcarefullystudiedBerkshireHathaway’sannualreportsfrom

thepast50years,his1958to1969partnershipletters,andasmanyofhisotherwritingsasIcouldfind.Ihavebenefitedimmenselyfromthiseffortandhavedonemy

besttocaptureBuffett’sinvestmentideasinthisbook.

HowMuchBackgroundDoYouNeedto

UnderstandBuffett’sPrinciples?

Buffettdoesnotrecommendsophisticatedmathematicalmodels.He

writes,“Toinvestsuccessfully,youneednotunderstandbeta,effi-

cientmarkets,modernportfoliotheory,optionpricing,oremerging

markets.”3Withthissentimentinmind,Ihavemadecertainthatyoudo

notneedanyknowledgeofmathematicalfinanceto

benefitfromthis

book.ConsistentwithBuffett’steachings,myexperiencetellsmethat

theuseofmathematicalmodelstopickindividualstocksisnotparticu-

larlyhelpful.Itmayevenbeharmfulbecauseitcanleadyoutobecome

overconfidentinyourabilities.Asthefinancialcrisisin2008–2009has

shown,over-relianceonmathematicalmodelscanresultinafalsesense

ofsecurityintheunderstandingofriskandreturn.

Someknowledgeofaccountingandfinanceis

essentialtofollowthis

book,butmostpeopleinvestinginthestockmarketalreadyunderstand

suchtermsasearnings,dividends,andreturnonequity.Myobjectiveistoshowhowtointerpretthosetermssothatyoucanusethemeffectivelytoimproveyourinvestingstyle.Ifyouhavenoknowledgeof

basicinvestmentterms,youmayfindsomesectionsofthisbookalit-

tleadvanced.Eventhen,youwillseethatthereismoretopickinga

stockthanbeingawhizinmanipulatingnumbers.Ifstockpickingcould

indeedbeformulatedasamathematicalmodel,mutual

fundmanagers

E1FPREF

Date:Jan19,2010

Time:11:46am

Preface

couldsimplyhireabunchofrocketscientistsandearn

superiorreturns.

Buttheevidenceisjusttheopposite:Itappearsthatinvestorswhouse

simpleprinciplesgenerallydobetterthanthosewhorelyheavilyon

mathematicalmodels.

ToconcentrateonBuffett’sinvestingprinciples,Irestrict

mydiscus-

siontoBuffett’sinvestment-relatedideas,howwecanlearnfromthem,

andwhytheywork.Othershavealreadyreviewedhisinterestinglife

story.4Idoubtthatyouneedtobeasfascinatedbybridgeorbaseballasheistobecomeasuccessfulinvestor.

Similarly,youneednothavebeen

borninOmaha,Nebraska,orsharehistasteinfood.Evenhisfriend

andbusinesspartnerCharlieMungerdoesnotagreewithallofBuffett’s

philosophicalideas.WhileBuffettisaDemocrat,MungerisaRepubli-

can.Youneednotbeeither.BykeepingthebookfocusedonBuffett’s

investmentphilosophies,Ihighlightonlytheissuesrelevanttoinvesting.

WhatCanYouLearnfromThisBook?

Thisbookisdividedintoninepartsand30chapters.Thereiscontinuity

acrosschapters,butyoucanreadmostofthemindependently.

InPartI(Chapters1and2),mymainobjectiveistoconvinceyou

thatinvestingislikesearchingforburiedtreasure.OnereasonBuffett

issuccessfulisthatheenjoysthisprocess,andyouare

morelikelyto

besuccessfulifyoutreatitasagameandhavefunwithit.Next,I

chronologicallyoutlineseveralimportanteventsinBerkshire’shistorytodrawinsightsintoBuffett’sphilosophy.Suchahistoricalbackgroundis

usefultokeeptheremainder

ofthebookinperspective.

PartII(Chapters3to6)explainsbasicinvestmentstrategies,so-called

valueinvestingandgrowthinvesting.Usingconcreteexamples,Iexplainhowyoumaycomputeintrinsicvalueandmarginofsafetybeforeyouinvest.

ParticularlyinChapter6,I

explainwhyBuffett’sstrategiesshouldnotbeclassifiedasvalueinvestinginthetraditionalsense.Hedoeswhatismostlogicalandfrequentlycombinesvalueandgrowthinvestingstrategies

effectively.Ingeneral,itisamistake,andwouldlimityourimagination,topigeonholeBuffett’sapproachintoanysingle

investingstyle.Hedoes

whatismostrationaltocreatevalueinthelongrun.Forlackofabetterterm,Isimplycallhimarenaissanceinvestor.

E1FPREF

Date:Jan19,2010

Time:11:46am

preface

InPartIII(Chapters7to9),IlookathowBuffettusesinsurance

togeneratecashflowsforotherinvestments.TounderstandBuffett,you

musthavesomeunderstandingofthe

insurancebusiness,whichisthe

mainstayofBerkshireHathaway.

InPartIV(Chapters10to13),IdiscussseveralofBuffett’sinvest-

mentsinretailing,utilities,andmanufacturing.Theseexamplesprovide

furtherinsightintohisemphasisongrowthandmanagementquality.In

PartV(Chapters14to17),IemphasizeBuffett’sopinionsconcerning

severalclassictopics,suchasdiversificationandrisk.

InPartVI(Chapters18and19),IdiscussBuffett’sthoughtsonmarket

efficiencyandthewaysinwhichyoumayincorporatehisthoughtsinto

yourdecisionmaking.

InPartVII(Chapters20to24),Ireviewseveralimportantissues

relatedtoprofitabilityandaccounting.Althoughthesechapterswillnot

makeyouanaccountant,theywillprovideyouwithaperspectivethat

isnotcommonininvestingcircles.

InPartVIII(Chapters25and26),Ifocusonpsychologybecauseto

beasuccessfulinvestor,youmustunderstandyourselfandthebiasesthatplayarolein

yourdecisionmakingandthedecisionmakingofothers.

PartIX(Chapters27to30)isdevotedtocorporategovernance,

Buffett’sthoughtsonCEOsandothermanagers,andwhyheemphasizes

appropriatecompensationstructurethroughoutafirm.Theconclusion

ofthebookdiscussesBuffett’semphasisondevelopingasuitabletem-

peramentforwinninginthemarket,justasabaseballplayerneedsto

developatemperamentforwinningonthediamond.

Overall,thebookwillallowyoutodiscoverthatBuffetthasachieved

successbyemphasizingtheimportanceofhigh-qualitymanagersmore

thananyothermetric.Hecallshismanagersthe“All-Stars”anddiscussestheiraccomplishmentslavishlyinBerkshireannualreports.Bycontrast,

mostresearchandteachingsinbusinessschoolsusefinancialnumbersas

thekeymetricforfinancialsuccessandunderstandingbusinesses.My

objectiveistodevelopyourunderstandingbeyondtheideasyoumay

havelearnedinyourcollegecourses,gleanedbyreadingarticlesinthe

popularmedia,orpickedupthroughanyotheroutlets.My

motivation

isnotjusttoproviderulesforinvestingbutalsotohelpimproveyour

mind-setforinvesting.Havingtherightmind-setispivotal,whether

youareanindividualinvestor,astudent,anacademic,oraprofessional

portfoliomanager.

PremC.Jain

E1FLAST

Date:Jan19,2010

Time:11:56am

Acknowledgments

WhenIinitiallynarratedWarrenBuffett’ssuccessstory,my

father,alwaysaphilosopher,

remindedmewhatIfre-

quentlyaskedhimwhenIwasachild:“Why?”Theanswer

isthatIamgrateful.IamgratefultomystudentsatWharton,Tulane,

andGeorgetownoverthepast25yearswhoaskedinnumerablequestions

andhelpedmefocusmythoughts.Mycolleagues,everskepticalaspro-

fessorsare,gavemethebenefitoftheirexplanationsandunderstanding

ofdifferencesbetweenhowacademicsthinkandhowbusinessmenand

moneymanagersthink.Iamsincerelygratefultomy

longtimefriend

LarryWeiss,whoreadanearlyversionoftheentirebookandwent

throughseveralchaptersoverandoveragainasIdevelopedmyideas.

MyspecialthanksgotomyfriendsValentinDimitrov,acarefulreader

andatrustedco-author,forhisdiscussionswithmeformanyyearsabout

Buffett’sprinciplesandforhisongoingcommentsonthemanuscriptat

differentstages,andNancyPitts,whoreadeverywordwithacriticaleye,askedmanyquestions,andhelpedimprovethemanuscript.IthankElisa

DiehlandCindyLeitnerforcarefullycopyeditingtheentiremanuscript

atdifferentstages.

Ihavebenefitedfrommycolleagues’andfriends’knowledgeabout

investingandBuffett.Theylistenedpatiently,sometimesarguedand

discussed,gavedetailedcomments,andcontributedtothebookin

manyways.Forthis,IthankReenaAggarwal,BillBaber,DaleBailey,

GaryBlemaster,JenniferBoettcher,JimBodurtha,RandyCepuch,

E1FLAST

Date:Jan19,2010

Time:11:56am

acknowledgments

PreetiChoudhary,GeorgeComer,GeorgeDaly,HemangDesai,Bill

Droms,JasonDuran,AllanEberhart,PatriciaFairfield,ThereseFlana-

gan,AlokeGhosh,JackGlen,ZhaoyangGu,IngridHendershot(babyb),

JimHeurtin,ManishJain,SaurabhJain,VarunJain,S.P.Kothari,

AmitKshetarpal,SubirLall,CharlesLee,JeffMacher,

AnanthMad-

havan,JimMarrocco,JerryMartin,AlanMayer-Sommer,JohnMayo,

ChuckMikolajczak,VishalMishra,LenkaNaidu,KusumNarang,

KeithOrd,SandeepPatel,LeePinkowitz,DennisQuinn,Sundaresh

Ramnath,KorokRay,PietraRivoli,SriniSankaraguruswamy,Carole

Sargent,MissieSaxon,JasonSchloetzer,PamelaShaw,PaulSpindt,

EmmaThompson,SheriTice,CathyTinsely,JoaquinTrigueros,Joanna

ShuangWu,andTeriYohn.IamcertainIhavenot

includedeveryone,

andIapologizetothosewhosenamesshouldalsoappearhere.

IthankWarrenBuffettforallowingmetousecopyrightedmaterial

fromhisletterstoshareholdersandothersources.Formyinitialeducationandensuinggifts

inlife,IcreditmyteachersinanelementaryschoolinasmalltowninIndia.Allmyearningsfromthisbookwillbedonated

tochildren’seducation.Mostimportant,Iamespeciallygratefultomy

parents,mybrotherSubhash,andmythreesistersGunmala,Kanak,and

Manjuandtheirfamiliesfortheirunwaveringloveandsupport.

P.C.J.

E1PART01

Date:Dec10,2009

Time:4:13pm

PartOne

INTRODUCTIONAND

BACKGROUND

InChapter1,Iexplainwhyitiseasytobeattheprofessionalmutual

fundmanagersandhow,withsomeeffort,youcanalsooutperform

themarketasawhole.Idemonstratethatinthelongrun,rewards

fromplayingthegameofinvestingarelarge.InChapter2,Iuseimpor-

tanteventsfromBerkshireHathaway’shistoryasabackdropforvarious

investinglessonsthatcanbelearnedfromWarrenBuffett.

E1PART01

Date:Dec10,2009

Time:4:13pm

Date:Jan18,2010

Time:3:29pm

Chapter1

TheThrillofInvesting

inCommonStocks

It’snotthatIwantmoney.It’sthefunofmakingmoneyand

watchingitgrow.1

—WarrenBuffett

WarrenBuffetthasoftenmentionedthatheenjoysrunning

BerkshireHathawayandhasfunmakingmoney.Iassume

thatyoutoowanttoearnhighratesofreturnonyour

investmentswhilehavingfundoingit.ItisnotdifficulttodoifyoumastercertainprinciplesthatBuffettfollows.Youplaybaseball,golf,bridge,

orthestockmarketbecauseitisenjoyable.Butyouenjoythegame

evenmorewhenyoudefeattheopponent,especiallywhenyoubeata

seeminglysuperiorplayer.Canyouwininthegameofinvesting?Yes,you

can,solongasyouarewillingputsomeeffortintoit.Andnotonlycan

youwin;thethrillofthegamearisesbecauseyoucan

winoften.You

haveweakopponents:“Mr.Market,”whosuffersfromup-and-down

moods,andprofessionalmoneymanagers,whocanbeoutperformed

justaseasily.2Thisgameisnotasdifficultasmostpeoplethink.Itisasmuchfunasatreasurehunt.

BerkshireHathawayisjustoneofthe

treasuresIhavediscovered.Thisintroductorychapterwillconvinceyou

thattherewardsfrombecomingabetterinvestorareenormous.Laterin

Date:Jan18,2010

Time:3:29pm

introductionandbackground

thebook,IexplainBuffett’sprinciplesandwhytheywork,sothatyou

mayusethemtoearnthose

rewardsbyinvestinginthestockmarket.

Howa1PercentAdvantageBecomes

a100PercentGain

OnlyoneinfiveactivelymanagedmutualfundsbeatstheStandard&

Poor’s(S&P)500index.Thus,ifyouinvestin

activelymanagedmutualfunds,youroddsofbeatingthemarketareonlyone-in-five.Theseodds

areindeedlow.Averysimpleapproachtoimproveyouroddsisto

investinindexfundsbecausetheirreturnswillbeclosetothemarket

returns.Byinvestinginindex

fundsinsteadofmutualfunds,yourodds

ofbeatingthemarketimprovefromone-in-fivetofour-in-five.Butwhy

stopthere?Ifyouhavesomemoneytoinvestforthelongrun,whynot

investincommonstocks?Withcommonstocks,youcanimproveyour

returnsevenmore,especiallyifyouenjoytheprocessandputsomeeffortintolearningtheprinciplesthatmasterinvestorslikeBuffetthavelaid

out.Anothergreatinvestor,PeterLynch,echoesthisviewpoint:“[A]n

amateurwhodevotesasmallamountoftimetostudycompaniesin

anindustryheorsheknowssomethingaboutcanoutperform95per-

centofthepaidexpertswhomanagethemutualfunds,plushavefun

doingit.”3

Howmuchskilldoyouneedtobemuchbetteroffthaninvesting

inactivelymanagedmutualfunds?Inthelongrun,notmuch!Letme

explain.Basedonalonghistoricalrecord,theexpectedreturnonthe

marketisabout7percentto10percentperyear.Forsimplicity,let’suse10percentasabenchmark.Then,yourreturnfromanaveragemutual

fundwillbeonly8percentbecauseabout2percentgoestowardexpenses

inrunningthemutualfund,whichincludesthemanagementfees.Ifyou

invest$1,000withamutualfundandthemutualfundgivesyouareturn

of8percentperyear,yourinitialinvestmentof$1,000

willbecome

$6,848in25years;thatis,youwillhaveanetgainof$5,848.

Assumethatyouareabletodevelopjusta1percentreturnadvantage

overthemarketinthegameofinvestingorpickingstocks.Remember

thatyoualsodonotincurthe2percentexpensesinfeesandcharges

whenyouinvestinmutualfunds.With1percentabovethemarket,or

Date:Jan18,2010

Time:3:29pm

35,000

30,000

25,000

20,000

15,000

Dollars

10,000

910111213141516171819202122232425

YearsfromInitialInvestment

Figure1.1

Growthof$1,000after25orIntermediateYearsatDifferentRates

ofReturn

11percentperyear,yourinitial$1,000investmentwillbecome$13,585

attheendof25years,whichisanetgainof$12,585.Thus,yournet

gainismorethantwicewhatyouwouldhavehadifyouhadinvestedin

mutualfunds.Itisalmostunbelievable,butthenumbersdonotlie.Even

ifyoudecidenottoputallyourmoneyunderyourownmanagement

andinvestallofitinindividualstocks,youmayfinditworthwhileto

takechargeofsomeofyourowninvestments.Ifnothing

else,itwillbe

agreatlearningexperienceandanewsourceofexcitement.

Anadditionaladvantageofinvestinginindividualstocksisthatyou

willpaylowertaxes.Ifyoupickyourinvestmentscarefullyanddonotsellthemforalongtime,youpay

substantiallylessintaxesthanifyouhad

investedinmutualfunds.Thus,evenifyoudonotdevelopa1percent

advantageoverthemarket,youwillcomeoutsubstantiallyaheadwhen

youjudiciouslyinvestinindividualstocksratherthanmutualfunds.

Figure1.1showswhat$1,000willbecomein10,15,20,and25years

ifyouearn5percent,10percent,or15percentperyear.Notethatif

youcanearn15percentperyear,youradvantageoverthemarketis

enormous.A$1,000initialinvestmentwillbecome

$32,919in25years

ata15percentannualrateofreturn.

The2008–2009stockmarketcrashmayhavemadeyoupessimistic

aboutinvesting.However,historytellsusthatyouhaveanadvantage.

Date:Jan18,2010

Time:3:29pm

Thiseventactuallyoffersyouagreatopportunitytofindgoodstocksto

investin.Buffettrecently

wroteintheNewYorkTimesthatforhispersonalaccount,heisbuyingcommonstocksinthismarket.4Another

legendaryinvestorwithanoutstandingrecordoverseveraldecades

writes,“OneprinciplethatIhaveusedthroughoutmycareeristoinvest

atthepointofmaximum

pessimism.”5So,spendsometimelearningto

investwisely.Let’sfirstlookatreturnsyouwouldhaveearnedifyouhadinvestedinBuffett’scompany,BerkshireHathaway.

HowMuchWouldYouHaveEarnedIfYou

HadInvestedwithBuffett?

Inthepast30yearsendingin2008,BerkshireHathawayhasgivenan

annualizedreturnofover23percentperyear.Thisistwicetherateof

returnyouwouldhaveearnedwiththeDowJonesIndustrialAverageor

theS&P500index.Obviously,WarrenBuffett’s

performanceisincred-

ible.Intermsofdollaramounts,ifyouhadinvested$1,000inBerkshire

Hathawayabout30yearsago,yourinvestmenttodaywouldamountto

about$500,000.Thelessonisclear:LearnfromWarrenBuffett’sinvest-

mentphilosophy,whichisdescribedthroughoutthisbook.Youmay

notbeabletoattainhislevelofsuccess,butyoudonothavetobe

WarrenBuffetttoearnrespectablereturnsinthestockmarket.Ifyou

canreplicateeven,say,one-fourthorone-thirdofthe

advantagehehas

overthemarket,youwillearnveryhighlong-termreturns.Theaver-

ageinvestorislikelytobearelativelysmallinvestor.Itiseasiertobeatthemarketwithsmalleramountsofmoneythanwithlargeinvestments.

WhenBuffettranhispartnershipsinthelate1950s

tolate1960s,his

returnswereevenlarger.Now,Buffettcannotinvestinsmallercompa-

niesbecausetheBerkshireportfolioissolarge.Butasmallinvestorhastheadvantageofbeingabletoinvestinsmallercompanies.ForBerkshire

asawhole,returnswere

higherwhenthecompanywassmaller,buteven

overthepast15years,theaverageannualizedreturnhasbeen12percent

comparedwithonlyabout6percentfortheS&P500index.

Youneverknow:Youmighthavetheskillstopicktherightstocks

andbecomeasgoodaninvestorasWarrenBuffett.Aslongasyouare

notreckless,thereislittledownsideintryingtofindoutwhetheryou

Date:Jan18,2010

Time:3:29pm

havesomeoftheskillstobesuccessful.OnegreatthingaboutBuffettisthathehaswrittengenerouslyaboutwhathedoesandhowhedoesit.If

youhavepatienceandthewillingness,let’sstart

learningaboutbusinessesandinvestingfromthemaster.

Conclusions

Buffetthasoftendescribedhisinvestingphilosophyassimplebutnoteasy.

Itissimpleinthesensethatallyouneedtodoistoidentifyoutstandingbusinessesthatarerunbycompetentandhonest

managersandwhose

commonstockissellingatareasonableprice.Buthowdoyouthat?

Thisbookmakestheprocessofdiscoveringthosebusinessesaseasyas

possible.

Date:Jan18,2010

Time:3:29pm

Date:Jan18,2010

Time:3:50pm

Chapter2

1965–2009:Lessons

fromSignificantEvents

inBerkshireHistory

Historyisphilosophyteachingbyexamples.

—Thucydides,anancientGreekhistorian

WhenWarrenBuffetttookcontrolofBerkshireHathaway

in1965,itwasasmalltextilemanufacturingcompanyin

NewEngland.Theprospectsofthetextileindustryatthe

timewereratherbleak.BuffetthastransformedBerkshireintoalarge

insurance,utility,manufacturing,andretailingconglomerate.In44years,thecompany’sbookvaluehasgrownfrom$19to$70,530perclassA

share,andthestockpricehascorrespondinglygrownfromabout$8

to$96,600.ThefollowinglistofsignificanteventsinBerkshirehistory

servestwopurposes.First,itisimportanttolearnfromtheexamples

othershaveset;andsecond,itpresentsaquicklookat

manyofBuffett’sprinciples.Inlaterchapters,wewillexploretheseprinciplesfurther.

Date:Jan18,2010

Time:3:50pm

1965:NotThrowingGoodMoneyafterBad

EventWarrenBuffettislistedasaBerkshiredirectorforthefirsttime,althoughheisnotyetthechiefexecutiveofthecompany.Startingto

accumulateBerkshiresharesin1962at$7.60pershare,

Buffettacquired

acontrollinginterestinthecompanyby1965withanoverallaverage

costof$14.86pershare.

LessonRevenuesatBerkshirehavebeendeclining,from$64million

to$49million,intheprior16years.However,thecompany

didnot

investmuchtopropupthedecliningtextilebusiness.Thedecisionnottoinvestinadecliningbusinessisagoodexampleoftheoften-usedmaxim:

“Don’tthrowgoodmoneyafterbad.”Berkshire’scashflowsareinstead

usedforbuyingitsown

sharesbackintheopenmarketandforinvestinginothersecurities.Themainlessonisthatoneshouldbecarefulininvestinginacompanythatisusingitscashflowstosustainadyingbusiness.

1967:InvestinYourCircleofCompetence

EventBerkshiremakesitsdebutintheinsurance

businessbyacquiringtwoinsurancecompaniesfor$9million:NationalIndemnityCompany

andNationalFireandMarineInsuranceCompany.Bothcompaniesare

basedinOmahawhereBuffettlives.

LessonBuffettprobablyhadalong-termplantoslowly

developthe

insurancebusiness.Thisisanearlyperfectexampleofhowalongjourneystartswithasmallfirststep.Heinvestswithinhiscircleofcompetence:insurance.

1973:CashFlowIsKing

EventBerkshireincreasesitsinvestmentinBlueChipStamps.

LessonInthetradingstampbusiness,thecompanyreceivescashin

advanceforstamps:anIOU.Thecompanydoesnothavetopayinterest

ontheseIOUs,anditcanusethecashthusreceivedforinvestments

Date:Jan18,2010

Time:3:50pm

1965–2009:LessonsfromSignificantEventsinBerkshireHistory11

inotherbusinesses.ThisisagoodexampleofBuffett’sphilosophyof

generatingcashflowwithlittlerisk.Theinsurance

businesshassimilar

characteristics.

1977:SuccessfulGrowth

EventTheinsurancebusinesscontinuestogrowatafastpacethroughexpansionandacquisitions.Buffettreportsthatintheprior10years,

insurancepremiumsgrewby

about600percent,from$22millionto

$151million.

LessonBuffett’sexcellentknowledgeoftheinsuranceindustryhelpshimtoidentifytopmanagersandthendelegatethemtorunindividual

units.Notethatinsurancewasnotafast-growing

industry.Outstanding

managersarethekeytosuccessfulgrowth.Investwiththemwhenyou

findsuchopportunities.

1980:BuyingSharesafterPricesFall

EventBerkshireinitiallyinvestedinGEICOin1976whenGEICO

wasclosetobankruptcy.BerkshireincreasesitsholdinginGEICOto

7.2millionshares,equaltoanequityinterestofabout33percent.

LessonBuffettexplainshisinvestmentsinGEICOandAmerican

Expressasfollows:

GEICO’sproblemsatthattimeputitinapositionanalogoustothatof

AmericanExpressin1964followingthesaladoilscandal.Bothwere

one-of-a-kindcompanies,temporarilyreelingfromtheeffectsofa

fiscalblowthatdidnotdestroytheirexceptional

underlyingeconomics.

TheGEICOandAmericanExpresssituations,extraordinarybusiness

franchiseswithalocalizedexcisablecancer(needing,tobesure,askilledsurgeon),shouldbedistinguishedfromthetrue“turnaround”situation

inwhichthemanagersexpect

—andneed—topulloffacorporate

Pygmalion.1

Date:Jan18,2010

Time:3:50pm

introductionandbac

kground

Buffetthasemphasizedthatmostturnaroundcandidatesdonotsuc-

ceed.However,GEICOandAmericanExpressareexceptionsbecause

theunderlyingbusinesseswerehealthy.Youshouldbuysharesaftera

precipitousfallinpricesonlywhenyoucanassessthatthecompany’sproblemsaretemporary.

1984:ReportedVersusTrueFinancialResults

EventBuffettdescribeshowestimatesoflossesintheinsurancebusinesscanbesubstantiallydifferentfromthefinaltally,and,therefore,reportedearningsaresubject

tochange.In1983,reportedunderwritingresults,

basedonestimatesin1983,indicatedalossof$33million;butayear

later,correctedfiguresturnouttobe$51million,about50percentmorethantheoriginalestimate.

LessonThefollowingstoryexplainsthatwhenmanagers

planto

manipulateearnings,itisnotdifficult.

Amanwastravelingabroadwhenhereceivedacallfromhissister

informinghimthattheirfatherhaddiedunexpectedly.Itwasphysically

impossibleforthebrotherto

getbackhomeforthefuneral,buthetold

hissistertotakecareofthefuneralarrangementsandtosendthebill

tohim.Afterreturninghome,hereceivedabillforseveralthousand

dollars,whichhepromptlypaid.Thefollowingmonth,anotherbill

camealongfor$15,andhepaidthat,too.Anothermonthfollowed,

withasimilarbill.When,inthenextmonth,athirdbillfor$15was

presented,hecalledhissistertoaskwhatwasgoingon.“Oh,”shesaid.

“Iforgottotellyou.WeburiedDadinarentedsuit.”2

Preparationoffinancialstatementsrequiresalargenumberofestimates.

Whenanalyzingacompany,youshouldexamineseveralyears’worth

offinancialstatements,notjusttherecentones.

1985:CapitalExpenditures

EventBerkshireHathaway

closesitstextileoperations,whichwasitsmainbusinesswhenBuffetttookcontrolofthecompanyin1965.

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Time:3:50pm

LessonBuffettwrites:“It[is]inappropriateforevenanexceptionallyprofitablecompanytofundanoperationonceitappearstohaveunendinglossesinprospect.”3Asanexample,BuffettstatesthatBurlington

Industries,anothertextilecompany,unsuccessfullyinvestedmorethan

$200pershareonthe$60

stock.Hewrites,“Whenamanagementwith

areputationforbrilliancetacklesabusinesswithareputationforpoor

fundamentaleconomics,itisthereputationofthebusinessthatremains

intact.”4Whenyouseeacompanymakingnewinvestmentsinadying

business(e.g.,theautoindustryintheUnitedStatesinrecentyears),youshouldnotinvestinthatcompany.

1986:CorporateJetsandOtherLuxuries

EventInsmallprint,Buffettwrites,“Weboughtacorporatejetlastyear.”5

LessonCorporatejetsareveryexpensiveandcostalot

tooperate

andmaintain,or,asBuffettputsit,“costalottolookat.”Whileit

seemsappropriateforBuffetttoacquireacorporatejet,heclearlyfeelsuncomfortable.AsBenjaminFranklinsaid,“Soconvenientathingitis

tobeareasonablecreature,sinceitenablesonetofindor

makeareasonforeverythingonehasamindtodo.”6Asaninvestor,youcanlearn

aboutacompany’strueculturefromitsspendingpractices.

1988:HoldingPeriodofanInvestment

EventBerkshirebuys14.2millionsharesofCoca-Colafor$592mil-

lion.WithrespecttothisfirstmajorpurchaseofCoca-Colastock,Buffettstatesthathisfavoriteholdingperiodisforever.Hefurtherstates,“Wecontinuetoconcentrateourinvestmentsinaveryfewcompaniesthat

wetrytounderstandwell.”7HealsorecallsMaeWest,“Toomuchofa

goodthingcanbe

wonderful.”8

LessonInabout10years,themarketvalueoftheCoca-Colastock

holdingwillincreasetenfold.OnereasonBuffettcanholdinvestments

forlongperiodsisthatheinvestsonlyincompaniesthatheunderstands

Date:Jan18,2010

Time:3:50pm

andthathaveoutstandingmanagement.WithrespecttoCoca-Cola’s

CEO,Buffettwrites:

Throughatrulyrareblendofmarketingandfinancialskills,Roberto

[Goizueta]hasmaximizedboththegrowthoftheproductandthe

rewardsthatthisgrowthbringstoshareholders.Normally,theCEO

ofaconsumerproductscompany,drawingonhisnaturalinclinations

orexperience,willcauseeithermarketingorfinancetodominatethe

businessattheexpenseoftheotherdiscipline.WithRoberto,themesh

ofmarketingandfinanceisperfectandtheresultisa

shareholder’s

dream.9

Excellentinvestmentopportunitiesarefewandfarbetween.When

youfindsuchstocks,youshouldbuyalotandholdthemfora

longtime.

1989:LookingFoolishVersusActingFoolish

EventIn1989,twonaturaldisastersaffectedtheinsuranceindustrysignificantly.First,HurricaneHugocausedbillionsofdollarsofdamage

intheCaribbeanandtheCarolinas.Second,withinweeks,California

washitbyanearthquakecausinginsureddamagethatwasdifficultto

estimate,evenwellaftertheevent.

LessonBeforethe1989naturaldisasters,premiumsintheinsuranceindustrywereinadequate.Unlikemanyothers,Buffettstayedawayfrom

unprofitablebusinesses.Immediatelyaftertheearthquake,thetableswereturned.Givenitsstrongfinancialposition,BerkshireHathawayoffered

towriteupto$250millionofcatastrophiccoverage,advertisingtheofferintradepublications.

AsBuffettexplains:“Whenratescarryanexpectationof

profit,we

wanttoassumeasmuchriskasisprudent.Andinourcase,that’salot.”10

Takinglargeriskswithadequatepremiumsisprofitableinthelongrun

butmayappearfoolish.Tothis,Buffettresponds:“Wearewillingtolookfoolishaslongaswedon’tfeelwehave

actedfoolishly.”11Thekeylessonistoactrationally,regardlessofhowitappearstoothers.

Date:Jan18,2010

Time:3:50pm

1990:PessimismIsYourFriend

EventForthebankingindustry,1990wasadisastrousyear.FearsofaCaliforniarealestatedisastercausedthepriceofWellsFargostocktofallbyalmost50percent.Buffettpurchasedanadditional4millionsharesin

WellsFargo,increasing

Berkshire’sholdingtoabout10percentofthe

bank’soutstandingshares.

LessonBuffettwrites:“Themostcommoncauseoflowpricesis

pessimism—sometimespervasive,sometimesspecifictoacompanyor

industry.”12Butyoualso

needtobecareful,Buffetcautions:“Noneof

thismeans,however,thatabusinessorstockisanintelligentpurchase

simplybecauseitisunpopular;acontrarianapproachisjustasfoolish

asafollow-the-crowdstrategy.Whatisrequiredisthinkingratherthan

polling.Unfortunately,BertrandRussell’sobservationaboutlifeingen-

eralapplieswithunusualforceinthefinancialworld:Mostmenwould

ratherdiethanthink.Manydo.”13In2008–2009,whenthestockmar-

ketwasdownbyabout40percent,Buffettwrites,

“Wheninvesting,

pessimismisyourfriend,euphoriatheenemy.”14

1991:Risk

EventMidway,PanAm,andAmericaWestenterbankruptcy,making

1991adisastrousyearfortheairlineindustry.BuffettestimatesthatBerkshire’s

investmentof$358millioninU.S.Airhaddeclinedby35percent

to$232million.Onlyayearearlier,BuffetthadwrittenthattheU.S.Airinvestment“shouldworkoutallrightunlesstheindustryisdecimated

duringthenextfewyears.”15

LessonThereisalwaysrisk

ininvesting,whetheryouinvestinairlinesorAIG.Itispossibletoloseasignificantpercentageeveninfixed-incomesecurities,althoughtheyaregenerallylessrisky.Thereisyet

anotherlessonabouttheairlineindustry:“Despitethehugeamountsof

equitycapitalthathavebeeninjectedintoit,theindustry,

inaggregate,haspostedanetlosssinceitsbirthafterKittyHawk,”16writesBuffett.

AfterhisexperienceswithU.S.Air,Buffettseemstohavedecidedthat

Date:Jan18,2010

Time:3:50pm

investingintheairlinesindustryisnotinhiscircleofcompetence.Ifyouinvestinyourcircleofcompetence,youarelikelytoavoidhighlyrisky

investments.

1992:StockSplits

EventBerkshire’sstockpricecrossesthe$10,000markforthefirsttime.

LessonAstockpricelevelshouldnotbeusedasanindicatorofpotentialreturns.Astocksplitisnothelpfulforalong-terminvestor.Buffettstates,“Overall,webelieveourowner-relatedpolicies—includingthe

no-splitpolicy—havehelpedusassembleabodyofshareholdersthatis

thebestassociatedwithanywidelyheldAmericancorporation.”17In

theend,whatmattersistheperformanceofthecompany.Donotinvest

inacompanyjustbecauseithashadastocksplit.In2009,

Berkshire

announcedthatitwouldsplititsclassBsharesfor50:1inconnection

withitsacquisitionofBurlingtonNorthernSantaFe.Withoutthesplit,

smallBurlingtonshareholderswouldnotreceiveBerkshiresharesina

tax-freeexchange.

1993:IdentifyingExcellentCEOs

EventBuffett’sadmirationforMrs.B,NebraskaFurnitureMart’sCEO,iswell-known.Inadmiration,hewritesthefollowing:

Mrs.B—RoseBlumkin—hadher100thbirthdayonDecember3,

1993.(Thecandlescostmorethanthecake.)Thatwasadayonwhich

thestorewasscheduledtobeopenintheevening.Mrs.B,whoworks

sevendaysaweek,forhowevermanyhoursthestoreoperates,found

theproperdecisionquiteobvious:Shesimply

postponedherparty

untilaneveningwhenthestorewasclosed.

ShecametotheUnitedStates77yearsago,unabletospeakEnglish

anddevoidofformalschooling.In1937,shefoundedtheNebraska

FurnitureMartwith$500.

Lastyear,thestorehadsalesof$200million,

alargeramountbyfarthanthatrecordedbyanyotherhomefurnish-

ingsstoreintheUnitedStates.Ourpartinallofthisbegantenyears

Date:Jan18,2010

Time:3:50pm

agowhenMrs.BsoldcontrolofthebusinesstoBerkshireHathaway,

adealwecompletedwithoutobtainingauditedfinancialstatements,

checkingrealestaterecords,orgettinganywarranties.Inshort,her

wordwasgoodenoughforus.

Naturally,IwasdelightedtoattendMrs.B’sbirthday.Afterall,she’s

promisedtoattendmy100th.18

LessonBuffetthasoftenemphasizedtheimportanceofasoundtrackrecord.Obviously,Mrs.Bdidnotneedahigh-leveluniversitydegreeto

runabusinesssuccessfullyoveralongperiodoftime.Buffettsawagreatopportunityinherabilitiesanddidnothesitatetobecomeherpartner.

InvestwithCEOswhohaveanexcellenttrackrecord.

1994:ExtraordinaryResultsinOrdinaryBusinesses

EventBuffettdiscussestheextraordinarysuccessofScottFetzer,aBerkshiresubsidiarythatwasacquiredin1986for$315million.He

writes,“HadScottFetzer

beenonthe1993500list—thecompany’s

returnonequitywouldhaverankedfourth.YoumightexpectthatScott

Fetzer’ssuccesscouldonlybeexplainedbyacyclicalpeakinearnings,amonopolisticposition,orleverage.Butnosuchcircumstancesapply.”19

ThenwhatdoesexplainScottFetzer’ssuccess?

LessonBuffettoffersthisexplanation:“ThereasonsforRalph’s[ScottFetzer’sCEO]successarenotcomplicated.BenGrahamtaughtme45

yearsagothatininvestingitisnotnecessarytodoextraordinarythingstogetextraordinaryresults.Inlaterlife,Ihavebeensurprisedto

findthatthisstatementholdstrueinbusinessmanagementaswell.Whata

managermustdoistohandlethebasicswellandnotgetdiverted.ThatispreciselyRalph’sformula.”20Onceagain,similartotheexampleofMrs.

B,learningtoidentifyexcellentmanagersthroughtheirtrackrecordwillhelp

youagreatdealinearningsuperiorreturns.

1995:CorporateAcquisitions

EventIn1995,BerkshireacquiresHelzberg’sDiamondShops.Inthisconnection,Buffettwrites,

Date:Jan18,2010

Time:3:50pm

Jeffwasourkindofmanager.Infact,wewouldnothaveboughtthe

businessifJeffhadnotbeentheretorunit.Buyingaretailerwithout

goodmanagementislikebuyingtheEiffelTowerwithoutanelevator.21

LessonUnlikeBuffett’sacquisitions,mostacquisitionsdonotworkwellbecausetheydonotcomewithexcellentmanagementandgood

underlyingbusinesseconomics.Themergersareoftenmotivatedby

hubrissoaptlyexplainedbyPeterDrucker:“Dealmakingbeatswork-

ing.Dealmakingisexcitingandfun,andworkingisgrubby.Running

anythingisprimarilyanenormousamountofgrubbydetailwork...

dealmakingisromantic,sexy.That’swhyyouhave

dealsthatmakeno

sense.”22Buffetthasregularlyquestionedtheacquisitionpracticesofmostmanagers,andsoshouldyou.

1996:SellingTooEarly

EventBerkshireHathawaybecomesthe100percentownerofGEICO

whenitpurchasestheshares

—about50percent—thatitdidnotalready

own.AlthoughBuffettfirstpurchasedGEICOsharesin1951onhis

personalaccount,hesoldthosesharesin1952,onlytolamenthisdecisionlater.Heboughtbackintothecompanyovertheyearsstartingin1976.

LessonBuffettexplainsthatalthoughhemadeaprofitwhenhesoldhisGEICOsharesfor$15,259in1952,“inthenext20years,theGEICO

stockIsoldgrewinvaluetoabout$1.3million,whichtaughtmealessonabouttheinadvisabilityofsellingastakeinanidentifiablywonderful

company.”23Onapersonalaccount,IfirstpurchasedmyBerkshireshares

in1987andsoldwithinayear,onlytoregretthatdecisionlater.IhavesincepurchasedmoreofBerkshireshares,anditiscurrentlymylargest

holding.Donotsellagoodstockforasmallprofit.

1996:HiringPractices

EventThe79-year-oldfounderandCEOofFlightSafetyInternational,AlUeltschi,sellshiscompanytoBerkshireHathaway.Alhashadalife-longaffairwithaviationandactuallypilotedCharlesLindbergh.Buffett

explainshishiringpracticesasfollows:

Date:Jan18,2010

Time:3:50pm

AnobservermightconcludefromourhiringpracticesthatCharlieand

IweretraumatizedearlyinlifebyanEEOCbulletinonagediscrimina-

tion.Therealexplanation,howeverisself-interest.It’sdifficulttoteachanewdogoldtricks.ThemanyBerkshiremangerswhoarepast70

hithomerunstodayatthesamepacethatlongagogavethemreputa-

tionsasyoungsluggingsensations.Therefore,togetajobwithus,just

employthetacticofthe76-year-oldwhopersuadedadazzlingbeauty

of25tomarryhim.“Howdidyouevergethertoaccept?”askedhis

enviouscontemporaries.Thecomeback:“ItoldherIwas

86.”24

LessonWhatmattersistheperformanceoftheindividual,andonlyonthatbasisshouldapersonbejudged,notonthebasisofage.AsBuffett

furtherexplains,“Almaybe79,buthelooksandactsabout55.Hewill

runoperationsjustashehas

inthepast:Weneverfoolwithsuccess.

Ihavetoldhimthoughwedon’tbelieveinsplittingBerkshire’sstock,

wewillsplithisage2-for-1whenhehits100.”25Ignoreageandother

prejudiceswhenevaluatingthosewithwhomyoushouldinvest.

1997:Patience

EventBerkshirereportsalargenontraditionalinvestmentof$4.6billioninlong-termzero-coupontreasurybonds.Ifinterestrateswereto

rise,Berkshirewouldloseheavily;andiftheinterestratesweretofall,Berkshirewouldmakeoutsizedgains.WhydidBuffettmakesuch

unconventionalinvestment?

LessonBuffettfirstexplainstheneedfordisciplinewhenthereisexuberanceinthestockmarket.

Underthosecircumstances,wetrytoexertaTedWilliamskindof

discipline.Inhisbook,The

ScienceofHitting,Tedexplainsthathecarvedthestrikezoneinto77cells,eachthesizeofabaseball.Swingingonlyatballsinhis“best”cell,heknew,wouldallowhimtobat.400;reaching

forballsinhis“worst”spot,thelowoutsidecornerofthestrikezone,

wouldreducehimto.230.In

otherwords,waitingforthefatpitch

wouldmeanatriptotheHallofFame;swingingindiscriminately

wouldmeanatickettotheminors.26

Date:Jan18,2010

Time:3:50pm

Buffettdecidednottoswing—thatis,nottomakeadditionalinvest-

mentsinthestockmarketin1997.However,healsomakesitclearthat

“juststandingthere,dayafterday,withabatonmyshoulderisnotmy

ideaoffun.”27Patience,althoughnoteasy,isnecessaryforsuccessin

investing.Whenstockpriceappearshighrelativetofundamentals,stay

awayfrominvesting.

1999:TakingResponsibility

EventBerkshirehastheworstabsoluteperformanceofBuffett’stenuretodateand,comparedwiththeS&P500index,theworstrelativeperformanceaswell.BuffettgiveshimselfaDincapitalallocation.

LessonItisaneverydaymattertoseecorporatemanagersblaming

otherswhentheircompany’sperformanceisbelowpar.Ifnotother

individuals,theguiltypartyisfrequentlytheclimateortheinterestrates.

Instead,withrespecttothe1999results,Buffettwrites:

EvenInspectorClouseaucouldfindlastyear’sguiltyparty:yourChair-

man.Myperformanceremindsmeofthequarterbackwhosereport

cardshowedfourFsandaDbutwhononethelesshadanunderstand-

ingcoach.“Son,”hedrawled,“Ithinkyou’respendingtoomuchtime

onthatonesubject.”My“onesubject”iscapital

allocation,andmy

gradefor1999mostassuredlyisaD.28

Donotblameothers.Whenyoutakeresponsibilityforyourfailed

investments,asBuffettoftendoes,itiseasiertolearnfromyourmistakesandavoidrepeatingtheminthefuture.

2000:SellinginEuphoria

EventBuffettmentionsthatthe“long-termprospectforequitiesingeneralisfarfromexciting.”29

LessonWithhindsight,onecanconcludethatBuffettshouldhave

soldsomeoftheholdingsbeforethestockmarketstartedtodecline

Date:Jan18,2010

Time:3:50pm

in2000.TheCoca-Colasharestradedatpricesashighas$85pershare

in1998.Tenyearslater,in2009,Coca-Colastockpriceisabout$45per

share.AsBuffetthasrecognized,thestockmarketdoesbecomeeuphoric

periodically,andthemainlessonisthataninvestorshouldsellinthosecircumstances.

2001:NotLosingFocus

WhenDisasterStrikes

EventOnSeptember11,2001,terroristsattacktheWorldTradeCen-

terinNewYorkandthePentagoninWashington,DC.

LessonBuffettestimatedthatinsurancelossessurroundingtheeventsofSeptember11were$2.2billion,oneofthelargestinBerkshirehistory.

EvenBerkshiredidnotanticipateaterroristattackandhadnot

protecteditselffromsuchamegadisaster.OnSeptember26,hewroteto

hismanagers:“Whatshouldyoubedoinginrunningyourbusiness?Just

whatyoualwaysdo...almostalloperating

decisionsthatmadesenseamonthagomakesensetoday.”30Essentially,Buffettsuggeststhatsuch

disasterscouldactuallypresentopportunitiesformanagerstoexpand

theirbusinesses.

2002:FinancialWeaponsofMassDestruction

EventUsingEnronasanexample,Buffettdiscussespossibilitiesofhugelossesfromderivativecontractsandhisdecisiontoclosedown

thederivativebusinessthatcamewiththeacquisitionofGeneralRein

LessonBuffettwrites,“Wetrytobealerttoanysortof

megacatastropherisk,andthatourposturemaymakeusundulyapprehensiveabout

theburgeoningquantitiesoflong-termderivativescontracts.”Hewas

remarkablyprescientinstating,“Inourview,derivativesarefinancial

weaponsofmassdestruction,carryingdangersthat,while

nowlatent,are

potentiallylethal.”31InvestorsinlargecompanieslikeEnron,WorldCom,

AIG,BearStearns,LehmanBrothers,FreddieMac,andFannieMaelost

allormostoftheirinvestmentsbecausethesecompaniesindulgedheavily

Date:Jan18,2010

Time:3:50pm

inderivativesthattheycouldhavedonewithout.Theimportantlesson

foranaverageinvestoristhatoneshouldavoidinvestingincompanies

withdifficult-to-understandbusinessmodelsorfinancialstatements.

2008-2009:MarketCrashes

EventDuringaspanofsixmonthsfromSeptember2008toMarch

2009,BerkshirestockclassAexperiencespricesashighas$150,000per

shareandaslowas$75,000,representingadeclineof50percent.The

marketasawholeexperiencesasimilardownturn.

LessonAsBuffettpointsout:“Amidthisbadnews,

however,never

forgetthatourcountryhasfacedfarworsetravailsinthepast....Withoutfail,however,we’veovercomethem.”32Thisisnotthefirsttimethat

Berkshire’sstockpricehasgonedownby50percent.Ithashappened

threeothertimessince

Buffetttookcontroloverthecompanyin1965.

Inrecentyears,from1998to2000,Berkshire’sstockpricedroppedby

about45percent,from$79,000to$44,000.Berkshirewasagoodbuy

aftersuchadecline.WhileIrecommendthatyoudoyourhomework,

late2009,inmyopinion,isstillagoodtimetobuyBerkshirestockand

stocksinotherconservativelyfinanced,prominentcompanies.

Conclusions

Fromitsfirstacquisitionoftwosmallinsurancecompaniesin1967,

BerkshireHathawayhasexpandeditsinsurancebusinessandbecome

oneofthelargestinsuranceoperationsintheworld.Theeventsand

milestonesofthepast44yearsdiscussedinthischapterreflectmanyof

Buffett’sdecisionsandpractices.Hislongand

successfultrackrecordandhiswillingnesstosharehisthoughtsmakeitpossibleforustostudyhisideasindepth.Therestofthebookisdevotedtodevelopingagood

understandingoftheinvestingprinciplesthatBuffettbothespousesand

exemplifiesandwhythoseprincipleswork.

E1PART02

Date:Dec10,2009

Time:4:15pm

PartTwo

BUFFETTINVESTING=

VALUE+GROWTH

Thephrasevalueinvestingpopularlymeansaninvestingstylebased

onfinancialratiossuchasprice-to-earningsormarket-to-book.

Bycontrast,ingrowthinvesting,oneseekstodiscovercompaniesthatarelikelytogrowatafastpaceinthefuture.InChapters3and4,Idiscussvalueinvestingandgrowthinvesting,respectively.Bothinvestingstyleshavemerits.Chapter5focusesonthe

conceptofintrinsicvalue,

thevalueyouassigntoastockbasedonitsassetsandearnings.InChapter6,IexplainhowwecanbestlearnfromBuffettbyviewinghimasan

integratorofbothvalueandgrowthinvestingprinciples.

E1PART02

Date:Dec10,2009

Time:4:15pm

Date:Jan29,2010

Time:12:55pm

Chapter3

ValueInvesting—It’sLike

BuyingChristmasCards

inJanuary

[W]ehadlearnedfromBenGrahamthatthekeytosuccessful

investingwasthepurchaseofsharesingoodbusinesseswhenthe

marketpriceswereatalarge

discountfromunderlyingbusiness

values.1

—WarrenBuffett

Ifyoulovebargains,youwilllovevalueinvesting.Valueinvesting

isregardedasthecornerstoneofBuffett’sinvestingstrategy.Value

investingissimilartobuyingsomethingwhileit’sonsale.Anevery-

dayexampleofvalueinvestingisbuyingChristmascardsinJanuaryat

abouthalfthepriceofthesamecardsamonthearlier,inDecember.IfyoubuyChristmascardsinJanuaryandusethemthefollowingChristmas,

youwillhaveimplicitlyearnedareturnofabout100percentonyour

investment.Ifyoutendtocomeupwithsuchideas,implementthem,

andcomputeyourpotentialreturns,youareanaturalvalueinvestor.For

valueinvestinginthestockmarket,youbuywhenprices

arelowrelative

tofundamentals(e.g.,earningsandbookvalue),andthenwaitforprices

tomoveup.

Date:Jan29,2010

Time:12:55pm

buffettinvesting=value+growth

Moststocksdonotsellforbargainprices,justasmostitemsinthe

localmalldonotsellforbargainprices.Gooddealsarenotavailableeveryday.

Aninvestormustbepatientandwaitforsuchopportunitiestoarrive.

Youneedpatiencetowaitforatrulyoutstandingvalueopportunity,and

youneedevenmorepatienceafteryoupurchaseastock.Itoftentakes

timeforpricetoreflectvalue.Inthecaseof

Christmascardinvesting,

youneedtowaitaboutayear.Inthestockmarket,thewaitisoftenevenlonger.

ThestockmarketalsohascomplicationsthatdonotariseinChrist-

mascardinvesting.WeknowthatChristmasarrivesfaithfullyevery

DecemberandthatanopportunitytoinvestinChristmascardsarrives

soonafter.Ontheotherhand,goodopportunitiesinthestockmarketdo

notannouncetheirarrival.Norcanyoualwaysanticipatetheindustryor

geographiclocationinwhichopportunitiesmightarise.

Furthermore,

youwillneverknowforsurethatanopportunityisstaringatyou.There

isnoguarantee:Youalwayshavesomechanceofendingupwithabad

outcome.Whilevalueinvestingisnotaseasyasitlooksatfirstglance,youcanbecomeagoodvalueinvestor

withtimeaslongasyoucarefully

followthephilosophydevelopedbyBenjaminGraham.

ValueInvestingandTwoEssentialPrinciples

BenjaminGrahamdevelopedthecoreprinciplesforinvestinginfinancial

securities.Tothebestofmyknowledge,heneverusedthetermvalue

investingtodescribehisapproach.FromwhatIcandetermine,hedidnotgiveanynametotheinvestingprincipleshedeveloped.Nomatter

whathecalledit,heisgenerallyknownasthefatherofvalueinvesting.

Muchhasbeenwrittenaboutvalueinvestinginthepastfewdecades,

butauthorsdefineitindifferentways.Thecommonelementsacross

variousdefinitionsfrombothpractitionersandacademicssuggestthat

valueinvestingimpliesaninvestingstylethat

emphasizesusingfinancialratiossuchastheprice-to-earningsormarket-to-bookratios.Theterm

valueinvestingisalsocommonlyinvokedwhenonedoesnotinvestinfast-growingcompaniesorstickstoconservativelyfinancedcompanies.

Avalueinvestorissomeonewhofocusesfirstand

foremostonpreserving

capital.Earninghighreturnsisdesirablebutsecondary.

Date:Jan29,2010

Time:12:55pm

ValueInvesting—It’sLikeBuyingChristmasCardsinJanuary

Howeffectiveisvalueinvestingasameansforgeneratinghigh

returns?Doesthisstylegenerateabove-marketreturns?Buffett’sinor-

dinatesuccessisgenerallyattributedtovalueinvesting.However,asI

willdiscussinthenextfewchapters,Buffett’sinvestingstyledoesnot

fitthepopular,butlimiting,definitionofvalueinvesting.Furthermore,weshouldnotrelyonevidencefromafewsuccessstoriestoconclude

thatvalueinvestinggenerateshighreturns.Anecdotalevidencedoesnot

proveaproposition;itcanonlyofferexamples.Withoutthescientific

evidenceprovidedbyresearch,wecanbeincorrectlyconvincedbyanec-

dotes.Academicresearch,aswewillseeinthischapter,stronglysupportsvalueinvesting,andthus,thereismorethananecdotalevidence

tosupportthemeritsofvalueinvesting.Butfornow,let’sfocusonthetwo

mostsignificantprinciplesemergingfromthevalueinvestingliterature,

primarilyfromGraham’svoluminouswritingsandinparticularfromhis

famousbookTheIntelligentInvestor.2Iexplainwhy

theseprinciplesworkandwhatmakesthemimportant.

Principle1:PriceShouldNotBeHighRelativetoaCompany’s

AverageEarningsoveraNumberofYears

Thefirstprincipleessentiallyrelatestothemostoftendiscussedratio

inthefinancialworld,theprice-to-earningsratio,orsimplytheP/E

ratio.ThemarketP/Eratiorosefrom18intheearly1990stoabout

30intheearly2000sasinterestratesdeclinedsteadilyduringthesame

period.Asinterestratesincreasedstartingintheearly

2000s,themarketP/Eratiodeclinedbacktobelow20.Duringthemid-1970stoearly

1980s,themarketP/Eratiowentdowntoaslowas7to9becauseof

highinterestratesandeconomicslowdown.Intermsofspecificnumbers,

afterevaluatingthecurrent

conditionsin1972,BenjaminGrahamstates,

“Wesuggestthatthis[P/E]limitbesetat25timesaverageearnings,andnotmorethan20timesthoseofthelast12-monthperiod.”3

Therearetwolessonsthatwecanlearnfromhistory.First,itisgen-

erallyagoodideatoavoid

investinginstockswhenthemarketP/Eratio

ishigh,sayhigherthan20.Second,wecanextendthesameargumentto

individualstocks,withonecaveat.Youshouldexamineacompany’sP/E

ratiooveranumberofyears,bylooking,perhaps,atthepriceinrelationtothepast

fiveto10years’earnings.Ifyouuseonlyrecentearnings,

Date:Jan29,2010

Time:12:55pm

Priceto10-yearaverageearnings

Averagefrom1881to2009

Price-to-earningsratio

Figure3.1Price-to-EarningsRatiofrom1881to2009

acompanymayhavealowP/Eratiobecauseearningsaretemporar-

ilyhigh,oritmayhaveahighP/Eratiobecause

earningsaretempo-

rarilylow.

Figure3.1showsthehistoryofthemarket’sP/Eratiowhereearnings

aredefinedastheaverageofthepast10years’earnings.Theaverage

ratioovertheentiretimeis16.3.4Thelatestratioof18.9

attheendofOctober2009isslightlyhigherthantheaverage.Youcanseethatwhen

theratioisveryhigh,itreversestowardtheaverageandfrequentlygoessubstantiallybelowtheaverage.Justbecausetheratioiscurrentlynear

theaveragedoesnotimplythatitcannotgoanyloweror

higher.Overall,thischartsuggeststhatiftheratioisveryhigh,asitwasin2005–2007,itisnotagoodtimetoinvest.Ontheotherhand,whentheratioisvery

low,itisagoodtimetoinvest.

SeveralsuccessfulinvestorshaveusedtheP/Eratioasthecoreof

theirinvestmentstrategy,includingJohnNeff,whoiswellknownfor

successfullymanagingbillionsofdollarsthroughtheVanguardWind-

sorFundformorethan30years—averylongtimeinthemutualfund

managementbusiness.Veryfewmutualfundmanagers

havemanaged

largeportfoliossuccessfullyforsuchalongperiod.WhywasJohnNeff

Date:Jan29,2010

Time:12:55pm

ValueInvesting—It’sLikeBuyingChristmasCardsin

January

sosuccessful?“WereliedonrelentlessapplicationsoflowP/Esympa-

thies,abettedbyattentiontofundamentalsandaliberaldoseofcommon

sense.”5

Investorsmayalsouseothervaluationratiossuchasthemarket-to-

bookortheS&P500earningsasafractionofgrossdomesticproduct

(GDP),whichBuffetthasreferencedinhiswritings.Attheaggre-

gatelevel,itdoesnotmatterwhichratioyouexamine.The

results

aresimilar.Attheindividualstocklevel,whetheryouusetheP/E

ratioorthemarket-to-bookratiooranotherratioentirely,youshould

dependonthenatureofthecompany’sbusinessandtheavailabilityof

suitabledata.

Principle2:EachCompanySelectedShouldBeLarge,Prominent,

andConservativelyFinanced

ThisprincipleisstraightfromGraham.Herecommendsinvestinginlarge

andprominentcompaniesbecauseitisnoteasytoevaluatesmalland

less-knowncompanies.Theirfinancialstatementsarelessreliable,and

theymaybemoreeasilyaffectedbyunforeseencircumstances.Inother

words,theriskinvolvedininvestinginsmallandless-

knowncompanies

ishigh.“WhereshouldIstarttolookforworthwhilecommonstocks?”

youmayask.Buffettoftenrecommendsthatanaverageinvestormay

startwiththeValueLinesheets.ValueLineusuallydoesnotfollowsmallcompanies.Thus,thefirst

criterionofinvestinginlargecompaniesis

easilymet.ValueLinealsoprovidesastock’shistoricalrecordovertheprior20years.Theavailabilityofalongtrackrecordisusefulbecause

youcandecidewhetherthecompanyisprominent.Youmayreadthe

ValueLinedescriptionofthecompanyandthendecidewhetheryouwanttoconductadditionalresearch.

RegardingGraham’spositionthatacompanyshouldbeconserva-

tivelyfinanced,itispossibletodiscussatgreatlengthwhatexactlythistermmeans.However,whetherthecompanyisconservatively

financed

willbeimmediatelyclearfromacursoryexaminationofitsshort-and

long-termdebtlevelsinrelationtoitstotalassets,oritsdebt-to-equityratio.Tomakelifesimpleforinvestors,ValueLineranksstocksonascaleofsafety,fromonetofive.Coca-Cola,amajorholdingofBerkshire

Hathaway,usuallyhasthehighestsafetyrankingofone.Alarge,

Date:Jan29,2010

Time:12:55pm

establishedcompanysuchasCoca-Cola,withamarketcapitalization

ofabout$100billionattheendof2008,hasonlyabout$3billion

oflong-termdebt.Itisnotdifficulttoconcludethatthecompanyis

conservativelyfinanced.

BerkshireHathawayhasalwaysbeenconservativelyfinanced.Whyis

conservatismimportant?Becauseitisdifficulttopredictwhenfundswillbesuddenlyneededforprofitableinvestmentsorforclaims.Aconservativelyfinancedcompanycanraisefundsinshortorder,andaliquidity

crisisintheeconomywouldnotaffectthecompany.Forexample,in

2008,largeandprominent(butnotconservativelyfinanced)companiessuchasCiticorp,GoldmanSachs,andGeneralElectricsufferedsignificantly,andseveralothersweremerged,declaredbankruptcy,orwereon

thevergeofbankruptcy.On

theotherhand,BerkshireHathawayused

thisasanopportunitytoinvestincompaniessuchasGoldmanSachsand

GeneralElectric.Thus,inthelongrun,conservativelyfinancedcompa-

niesarelikelytoproducehigherreturnsastheyareinapositiontotakeadvantageof

suchopportunities.

WhileIconsiderthesetwoprinciplesorguidelinestobemostimpor-

tant,theyareprinciplesandnotspecificrules.Forexample,notalllargecompaniesmaylendthemselvestosoundfinancialanalysisbecauseof

thecomplexityoftheir

business.Itmaynotbeeasytodefinewhich

companyisprominentandwhichisnot.Thus,youwillhavetouse

afairamountofjudgmentinselectingyourinvestmentseveninyour

applicationoftheseprinciples.

OtherHelpfulGuidelinesforValueInvesting

Tohelpyouwithnarrowingyourfieldofinquiry,Idiscusssomeofthe

morecommonconceptsthatBuffettandothervalueinvestorshaverelied

onoverthedecades,conceptsthathavewithstoodthetestoftime.

ASharpDeclineintheStockMarket

Asharpdeclineinthestockmarketgenerallypresentsagoodinvestment

opportunity.Inmid-1973,afterthemarkethaddeclineddramatically,

Date:Jan29,2010

Time:12:55pm

BerkshireHathawayboughtalargestakeof1.9millionsharesinthe

WashingtonPostCompany(WPC).Youmightthinkthat

onlyBuf-

fettcouldseethatthecompanyofferedsuchagoodopportunity.He

suggestedjusttheopposite:“Calculatingtheprice/valueratiorequired

nounusualinsights.Mostsecurityanalysts,mediabrokers,andmedia

executiveswouldhaveestimatedWPC’sintrinsicvalueat$400to$500

million,justaswedid.Andits$100millionstockmarketvaluewas

publisheddailyforalltosee.”6In2009,evenaftera50percentdeclineinitspriceinrecentyears,WPCistradingatabout$400pershare,and

ithaspaidregulardividends.Berkshire’sinvestmenttranslatesintoan

annualizedreturninexcessof15percentperyearincludingdividends,

anexcellentreturncomparedtoabout9percentinthemarketduring

thisperiod.

Dependingonyourlevelofrisktolerance,itisreasonabletoargue

thatyoushouldincreaseyourinvestmentinthestockmarketwhenever

thereisa20percentcorrectionfromreasonablepricelevels.Itisnot

thepricedeclinepersethatisimportant;itisthepricein

relationtoearnings,asthesecondprinciplementionedearlierrequires.Perhapsa

marketP/Eofabout12suggestsopportunitiesbasedonthefactthatthe

long-runmarketP/Eaverageisabout16.Ofcourse,suchaninvestment

shouldnotbefortheshorttermbecausethedecline

couldcontinue

foraconsiderabletime.Youshouldcertainlygaugethevaluationsofthe

marketasawholeinrelationtoitsfundamentals.Ifthedeclinecontinues,youmaythinkaboutincreasingyourinvestment.Thus,insomecases,

youwillhavetowaitalong

whileforthestockmarkettocomeback.

Patience,onceagain,isaprerequisiteforearningsuperiorreturns.

In2008,theS&P500indexdeclinedbyabout37percentand

evenBerkshireHathaway’sstockpricedeclinedby32percent.Arethere

opportunitiesinthismarket?Buffettthinksso.Inanop-edarticleintheNewYorkTimes,October17,2008,hewrote:“I’vebeenbuyingAmericanstocks.ThisismypersonalaccountI’mtalkingabout,inwhich

IpreviouslyownednothingbutUnitedStatesgovernmentbonds.”Of

course,noone—noteven

WarrenBuffett—cantimethestockmarket

perfectly.SinceOctober17,whentheS&P500indexstoodat940,it

declinedtoaslowas676,oradeclineof28percent,byearlyMarch2009.

Thesearetryingtimesforinvestorsallovertheworld.ItisdifficulttobeE1C03

Date:Jan29,2010

Time:12:55pm

optimisticinrecessionarytimes.However,“wheninvesting,pessimism

isyourfriend,euphoriathe

enemy.”7

TheIndustryThatLeadstheDecline

Thestockmarketdeclinein2008and2009waspervasiveacrossmany

industries,althoughfinancialstockshavebeenhitespeciallyhard.Such

pervasiveslidesare

uncommon.Usually,a10percentto20percent

declineisledbyoneorafewindustries.Inthoseinstances,theindustrythatleadsthedeclinemayleadtherecoveryandofferearlyinvesting

opportunities.Forexample,inthefallof1998,Russiafacedapayment

crisisanddefaultedonitsdebt.TheU.S.stockmarketwentdownby

about20percent,ledbythefinancialandtechnologysectors.Thesame

sectorsthenprovidedthemostgainsinthefollowingyear.Ingeneral,

whenamarketdeclineisledbyoneortwoindustrial

sectors,itisworthwhiletopayspecialattentiontogoodcompaniesinthosesectors.Even

inthesesituations,itisimportanttokeepinmindthatyoushouldinvestonlyifyouarecomfortablewiththefundamentalsofthecompany.

DuringtheRussiandefaultcrisis,thestockpriceof

MerrillLynch

declinedfromahighof$102pershareinJuly1998to$42persharein

October1998,a60percentdrop.Inmyview,itwasasubstantialdecline

andofferedanopportunityforhigherreturnsinthefuture.Thefollowingyear,MerrillLynch’sstockprice

wentupbyabout100percent.Merrill

Lynch’sbusinesswasnotdifficulttoanalyzeatthetime.(Itsbusiness

becamemorecomplexseveralyearslater.)Itwasnottheonlycompany

thatofferedthiswonderfulopportunity.Youcouldhaveboughtinto

anyofthewell-knownfinancialcompaniesanddonewell.Theaverage

declineinthewell-knownstocksofCitigroup,ChaseManhattan,and

BankofAmericawasabout50percent.Andeachoneofthemservedup

a100percentreturnin1999.Althoughitisnoteasyto

timethemarket,

opportunitieslikethesearelargeenoughtoofferasubstantialmargin

ofsafety.During1998,Berkshirepurchasedabout1millionadditional

sharesofAmericanExpress,increasingitsholdingto50.5millionshares.

Thedecisiontopurchasewasprobablyinfluencedbythedeclineinthe

sharepriceofAmericanExpress.Duringthe2008–2009marketcrash,

AmericanExpress,onceagain,wentdownfrom$60persharetoabout

$10pershare,onlytoreboundto$40pershare

withinayear.

Date:Jan29,2010

Time:12:55pm

WatchOutforTemptations

Valueinvestingdoesnotsuggestthatoneshouldinvestindiscriminately

whenacompany’sstockpricedeclinesandthestocklookscheaprelative

toitspriceafewmonthsearlier.Ifyoustartbuyingthingseverytime

youwalkintoastorethatishavinga50percentoffsale,youwillsoonbeindebtorbankruptcy.Allitemsonsalearenottrueinvestmentbargains

butareinsteadinvitationstocollectjunk,onlytobesoldatyournext

garagesaleforafractionofwhatyoupaid.Bewareofthesetempting,

yetmisleading,so-calledbargains.

Kmarthasoftenappearedasabargainstock.TheriseofWal-Martas

asuccessfulretailerledtothedeclineofKmart’sstockpriceintheearly1990s.AteverystageofKmart’spricedecline,thestockappearedtobe

abargainifyoulookedatitsP/Eratio.Afteralmostadecade,thestockpricewasonlyabout$9pershare,havingdeclinedfromahighof$27in

theearly1990s.Itcontinuedtolookinexpensiverelativetoitsearningspershare—andunfortunately,IinvestedinKmart.IprovedGraham

right:“Observationover

manyyearshastaughtusthatthechieflosses

toinvestorscomefromthepurchaseoflow-qualitysecuritiesattimesoffavorableconditions.”8DuringthetimethatKmart’sstockpricewas

declining,themarketwentupabout300percent,andWal-Martwasa

phenomenalsuccess,amassingagainofabout700percent.IfIhadmade

afewtripstoKmartstoresanddugdeeperintoitsfinancialstatements,

itwouldhaveoccurredtomethatKmartwasalow-qualitycompany

relativetoWal-Mart.Andlow-qualitycompaniessuch

asKmartdonot

survive.In2002,Kmartwentbankrupt.

Often,companiesgetintotroubleandtheirstockpricesfall

significantly.Theyappeartobegoodturnaroundcandidates.Most

turnarounds,however,donot

endupsuccessful,andyoushouldnot

betemptedtoinvestinthem.Thus,alowpriceisnotagoodindicator

forinvesting.Outstandingturnaroundstories,suchasthatofChryslerinthe1970s,giveinvestorshopethatothercompaniesintroublemayturn

aroundinthesamemanner.However,unlessyouareinapositiontosee

thattheturnaroundisindeedhighlyprobable,youshouldnotinvestin

turnarounds.

TheprincipleofavoidingturnaroundsislikeavoidingChristmastree

(asopposedtoChristmascard)investing.TowardtheendofDecember,

Date:Jan29,2010

Time:12:55pm

Christmastreesareavailableatthrowawayprices,ifnotforfree.Fromaninvestmentperspective,buyingaChristmastreeattheendoftheseason

isawasteofmoney.Thepriceislow,butthevalueisevenlower.Ina

fewdays,whenthetreehasturnedbrownandsheditsneedles,itwill

havetobethrownaway.

DoesValueInvestingReallyWork?

Afterthisdiscussionofvalueinvesting,youmightaskifthereisreliableevidenceinsupportofvalueinvesting.Academicshaveaskedthisquestionforalongtimebecausetheyareusuallynotsatisfiedbyanecdotal

evidence.Buffetthasaddressedthisissuehead-on.SpeakingatColumbia

Universityin1984,hepresentedtheperformancerecordsofsevendis-

ciplesofBenjaminGraham.Healsoincludedtheperformanceoftwo

pensionfundsforwhichhehadhelpedselectmanagers

withvalueorien-

tation.Theresultsshowthatvalueinvestorsdoverywell.Buffettwrites:

“[I]fyoufoundanyreallyextraordinaryconcentrationofsuccess,you

mightwanttoseeifyoucouldidentifyconcentrationsofunusualcharac-

teristicsthatmightbecausalfactors.Scientificinquirynaturallyfollowssuchapattern.”9Inthiscase,themaincommoncharacteristicwasthe

valueinvestingapproachthatalltheGrahamdiscipleshadfollowed.

ItisnotsurprisingthatBuffett’sfindingsdidnothaveanyeffecton

thegeneralacademicopinion,atleastuntilrecently.Academicsusually

relyonevidencefromverylargedatasetsandareconvincedonlywhen

astrategyhasbeenshowntoworkoverlongperiods.Inotherwords,an

academicstudywouldconcludeinfavorofan

investmentstrategyonly

ifevenamonkey(computer)couldreplicatethestrategy.Inmyopinion,

thisisnotnecessarilyaverygoodapproachtoadvanceourknowledge,

butitistheacademicstandard.Nevertheless,recentacademicresearch

seemstohaveturnedthecornerinfavorofvalueinvesting.

AcademicResearchEvidence

Academicresearchisbasedonanalyzinglargesetsofdatausingextensivecomputerpower.Weshouldkeepinmindthatitisalmostimpossibletoprogramacomputertoidentifywhat

BenjaminGrahamcalls

“large,prominent,andconservativelyfinanced”companiesoridentify

Date:Jan29,2010

Time:12:55pm

ValueInvesting—It’sLikeBuyingChristmasCardsin

January

high-qualitymanagement.Forexample,howwouldacomputerknow

thattheCEOofBerkshireHathawayisagoodmanager?Forthisreason,

qualitativevariablesareallbutignoredinmostacademic

studiesortheirtreatmentissimplistic.Indefenseofacademicstudies,thegoodnewsis

thatthosestudiesmeetthehighestpossiblestandardsofanystudiesof

largedatasets,andeverythingaboutthemethodologyisclearlylaidout.

Hence,theydoprovideusreliablestatisticalresultstoponder.

Researchhasshownthatevensimplevalueinvestmentstrategies,

suchasinvestinginlowP/Estocks,produceoutstandingreturnsovera

numberofyears.Theseresultshavebeenreplicated

bymanyresearchers

overdifferentperiodsandare,thus,reliable.Therefore,itcanbe

concludedthataninvestorwhoimplementssimplevalueinvestment

strategiesandusesotherdiscerningqualitativevariablesshouldobtain

evenbetterreturns.Grahampointsoutthat“[an]investorshouldstart

withthelow-multiplier[i.e.,lowP/E]idea,butaddotherquantita-

tiveandqualitativerequirementstheretoinmakinguphisportfolio.”10

ManyapparentlowP/EstockssuchasKmartand

BethlehemSteelwould

nothavebeenselectedbycarefulvalueinvestorsbecausethecompanies

wereneitherprominentnorconservativelyfinanced.Inthenextsec-

tion,Idiscusstwosetsofstudies.Ifirstpresentadiscussionofstudiesthatcompareperformancesof

portfoliosconstructedbyhighversuslow

P/Estocks,andthenIcompareperformancesofportfoliosconstructed

byhighmarket-to-bookversuslowmarket-to-bookstocks.

PerformanceofHighversusLowP/EStocks

Themostprominentofrecentstudiesonvalueinvestingwasconducted

byProfessorsJosephLakonishokfromtheUniversityofIllinoisand

AndreiShleiferandRobertVishnyfromtheUniversityofChicago.11

TheyformedportfoliosbasedonP/Eandseveralother

ratiostoexamine

annualstockreturnsfrom1963to1990.InTable3.1,Ipresentresults

fromasimilaranalysisIconductedthatincludesreturnresultsuntil2007.

Thetablefirstshowsreturnsto10differentportfoliosofstocksformed

annuallyonthebasisofP/Eratios.Portfolio1iscomposedof10per-

centofthestockswiththehighestP/Eratios,ortheextreme-glamour

stocks.12Similarly,Portfolio10iscomposedofstockswiththelowest

P/Eratios,ortheextreme-valuestocks.

Date:Jan29,2010

Time:12:55pm

Table3.1

EvidenceThatValue

InvestingWorks

ReturnsonPortfoliosofStocks

ReturnsonPortfoliosofStocksBased

BasedonMarket-to-Book

onPrice-to-Earnings(P/E)Ratios

(M/B)Ratios

Portfolio

Return

Portfolio

Return

number

(%peryear)

number

(%peryear)

HighestP/E

HighestM/B

stocks

LowestP/E

LowestM/B

stocks

TheportfoliosofthelowestP/Estocksbeattheportfoliosofthe

highestP/Estocksbyaconsiderablemargin.Thecorrespondingreturns

are15.9percentversus9.4percentperyear.Lakonishokandcolleagues

showthatoverafive-yearperiodafterformationoftheportfolios,the

extreme-value(lowestP/E)stocksearna138.8percentreturnincom-

parisontoa71.1percentreturnfortheextreme-

glamour(highestP/E)

stocks.Thus,overafive-yearperiod,thelowestP/Estocksoutperform

thehighestP/Estocksbyafactorofalmosttwotoone.Evenifyoudid

notinvestinonlythelowestP/Eportfolio,theperformanceisgenerally

betterforthelowerP/EstocksthanforthehigherP/Estocks.These

resultssupportBenjaminGraham’sideasonvalueinvesting,whichshould

encourageyoutofollowhisapproach.

PerformanceofHighversusLowMarket-to-BookStocks

Theaccountingvalueofacompany’scommonstockasreportedon

thebalancesheetisknownasthebookvalue.Itisbasedonaccountingrulesandprocedures.Ontheotherhand,thepricepershare,orthe

Date:Jan29,2010

Time:12:55pm

marketvalue,receivesalotofattentionandisdeterminedbythemarket.

Generally,ifacompany’searningsareexpectedto

increaseatahighrate,themarketpriceissubstantiallyhigherthanthebookvalue.Aninvestor

shouldask:“Howhighshouldthemarketpricebeincomparisontothe

bookvalueinordertoinvest?”Thereisnogeneralformulatoanswer

thisquestion.Therefore,an

investorshouldexaminethehistoricalratiosofthesamefirmaswellastheratiosofotherfirmsinthesameindustry.Ifthemarketpriceissubstantiallyhigherthanthebookvalue,itislikelythatthepriceistoohighforavalueinvestortochoosethestock.Ontheotherhand,ifthemarketpriceisnotveryhigh,thevalueinvestorshouldlookfavorablyandpossiblyinvestinthestock—

keepinginmindGraham’s

viewthatthecompanyshouldbelarge,prominent,andconservatively

financed.

TheresultsofacomprehensivestudyconductedbyEugeneFama

andKennethFrenchoftheUniversityofChicago

supporttheideathat

investinginlowmarket-to-bookratiostocksresultsinhigherreturns.13

FamaandFrenchexaminedmonthlyreturnsforalargenumberofstocks

fromJuly1963toDecember1990,aperiodofmorethan27years.I

replicatetheiranalysisusingrecentdata,andthoseresultsarepresentedinTable3.1.Theextreme-valueportfolioincludes10percentofthelowest

market-to-bookstocks,whereastheextreme-glamourportfolioconsists

of10percentofthehighestmarket-to-bookstocks.Thedifferencein

returnsacrossthetwoextremedecileportfoliosisabout6percent.Usingthemarket-to-bookmetric,Lakonishokandcolleaguesalsoreportresults

forafive-yearstrategyinwhichthestocksareheldforfiveyearsonce

theportfoliosareformed.Theyfindthatforafive-yearholdingperiod,

theextreme-valueportfolioearns146.2percentasopposedtoonly56.0

percentfortheextreme-glamourportfolio.Theconclusionfromthese

studiesisthatthevalueinvestmentstrategyworkswellenoughthatyou

shouldbeabletobeatmostoftheprofessionalmoney

managerswho

focusonshort-termresults.

ThePowerofMultipleVariables

BeyondtheP/Estrategyorthemarket-to-bookstrategy,researchershave

examinedportfoliosformedonthebasisofseveralothervariables.In

particular,portfolioformationsbasedoncash-flow-to-priceandgrowth

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inpastsalesorassetssupportthevalueinvestingapproach.Itisbettertobuyhighcash-flow-to-pricethanlowcash-flow-to-pricestocks,and

similarly,itisbettertobuystockswithlowpastgrowthinsalesthanhighpastgrowthinsales.Inaddition,whentworatiosareusedsimultaneously,theresultsareevenstronger.

Usingtwovariables(e.g.,growthinsalesandP/E),Lakonishok

andcolleaguesformninestockportfolios.Thestocksareindependently

sorted,inascendingorder,intothreegroupsofbottom30percent,mid-

dle40percent,andtop30percentbasedoneachofthe

twovariables.

Returnspresentedarecompoundedfive-yearpost-formationreturnsand

assumeannualrebalancingofthesenineportfolios.Theimportantcon-

clusionfromthisanalysisisthatavalueinvestmentstrategybasedjointlyonpastperformance(growthin

sales)andexpectedfutureperformance

(P/Eormarket-to-bookratio)produceshigherreturnsthanstrategies

basedexclusivelyononevariable,suchastheP/Eratio.

FrequentlyAskedQuestions

Anyinvestingstrategythathasbeenshowntoworkshouldbelookedat

morecarefullythroughprobingquestions.Inthissection,Idiscussthreefrequentlyaskedquestions,whicharerelevantwheneveraninvestment

strategyisbeingevaluated.Thisdiscussionshouldhelpyoubetterappre-

ciatetheevidenceandhelpyouthinkaboutevaluatingotherstrategies

thatyoudevelopyourself.

HowLongDoesItTakeforValueInvestingtoYieldSuperiorReturns?

Theresultsshowthatwhilereturnsarenotoutstandinginthefirstyear

aftertheportfoliosareformed,theyarenotdiscouraging.Thevalue

strategydoesworkinthefirstyear,butthedifferenceofabout4percentto6percent(dependingonthestudy)isnotremarkable.Insubsequent

years,thedifferenceislarger.Lakonishokandcolleaguesshowthatbythe

fifthyear,thedifferenceisalmost8percentperyear,whichissubstantiallylargerthanthefirst-yearfigure.

Theseresultsshowthatittakesseveralyearsofpatiencetobenefit

fullyfromthevaluestrategy.Aninvestorneedstobeextremelypatient

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aftertheportfolioisformed.Theanalysesperformedarebasedonthe

assumptionthattheportfoliosarenotbalancedfrequently.Oneimpor-

tantpointtorememberisthatifanindividualstockintheportfoliogoesupinpriceandnolongerqualifiesasalowP/Estock,itshouldnotbe

soldimmediately.Itshouldbeheldatleastuntilsuchtimeastheentireportfolioisreevaluated.Bynomeansam

Isuggestingthatyoushould

putallyourhard-earnedmoneyinsuchastrategyinonego.Aswith

anystrategy,youshouldslowlylearntheinsandouts,investalittleatatime,anddevelopyourskills.

Onenicesideeffectofthisanalysisisthatonceaportfolioisfully

formed,youneednotmonitortheportfolioonaregularbasis.Ideally,

theinvestorshouldnotcomebacktoevaluatetheportfolioforseveral

years.Ihaveoftendescribedthisstrategyas“lesseffortisbetterthanmoreeffort,”or,succinctly,“lessismore.”Avalueinvestorshouldspendmoretimeatthebeachthan

attheoffice.Isvalueinvestingreallyaseasyasitsounds?Yes,itis,butitwon’tbeifyoudonothavethepsychologicalresolvetorefrainfromtouchingtheportfolioforalongtime.Todevelopthepsychologicalresolve,youprobablyneedtoanalyzebyyourselfthe

historicaldataofthestocksinyourportfoliotobecomecomfortable

withtheirpastperformanceandtheresultspresentedhere.

Suchananalysiswillalsomakeyoumorecomfortablewiththevalue

strategy.Then,youwillindeedenjoythetimeyousavebynotwatch-

ingyourportfolioconstantly.Overall,totrulybenefitfrom

thevalue

investmentstrategy,youshouldnotunderestimatetheeffortneededtolearnaboutthestrategy.Youneedtopracticealot.Ifitwerepossible

todevelopthepsychologicalresolvebyreadingafewarticlesorbooks,

enoughinvestorswouldhave

followedthevalueinvestmentstrategyto

makeitsbenefitsgoaway.Thatpromptsthequestion:Doyouhavethe

righttemperamentforvalueinvesting?Thereisonlyonewaytofind

out.Practice.

AretheP/EandOtherValue

StrategiesLikelytoWorkintheFuture?

Aninvestorshouldalsoaskorthinkaboutwhetherastrategythathas

workedinthepastwillcontinuetoworkinthefuture.Noonecan

guaranteethat.However,giventhatpeoplegenerallygetexcitedabout

glamourstocksandnewinvestorscontinuallycometothemarket,such

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strategiesarelikelytoworkinthefuture.Asmentionedbefore,enoughpeoplewilllackthepsychologicalresolvetoholdthesameportfolio

andnottradeoften.DavidDremanwroteabookin1977thatexplains

theP/Estrategyindetail.Beforethat,GrahamandDodddiscussedthis

topicintheirbooks.Atallthesepoints,areaderwouldhavewondered

ifthestrategywouldworkinthefuture.AsshownbyLakonishokand

colleagues’research,areaderwouldhavedoneverywellindeedifhe

orshehadadoptedthevaluestrategyevenafterthe

publicationofthe

Dremanbook.Dremaneventuallywroteanotherbook,publishedin

1998,thatconfirmedhisearlierfindings.14

Clearly,therewillbeyearsinwhichtheP/Eorothervalueinvest-

mentstrategieswillnot

work.Theinvestorhastohavepatienceinthose

yearsandremaininvested.Anothermainproblemliesinthefactthatif

youweretoexaminethetypesofstocksthatareintheextreme-value

portfolios,youwouldfindthemhighlyunattractive.Often,theso-called

extreme-valuestocksdefinedinthesestudiesaresmallandhavehigh

financialleverage.Thus,eventheseacademicstudiesdonotdofulljus-

ticetowhatGrahamproposesyoushoulddoasoutlinedintheprinciples

discussedearlier.Overall,itisgratifyingthatGraham’s

principlesarevin-dicatedbymodernacademicwork.Ifyouareavalueinvestor,youmay

continuetopracticeyourstrategyandtrytomakeitbetterbyreading

BuffettandotherdisciplesofGraham.

AreValueInvestmentStrategiesRiskier?

Thisisalegitimatequestionbecause,astheoldsayinggoes,ifadeal

lookstobetoogoodtobetrue,itprobablyis.Thedealsexplainedin

theprevioussectionintermsofvalueinvestmentstrategiesseemtobe

toogoodtobetrue.Athoughtfulinvestorneedsto

takeintoaccount

thepossibilitythatthereasonthatvalueinvestmentstrategiesoffersuchexcellentreturnsisthattheyareriskier.Ifthatweretrue,ascientificinquirywouldshowthat.Ifvalueinvestmentstrategiesweremorerisky

andproducedhighreturns,theinvestorshouldatleastbe

awareofthat

possibilityand,indeed,bemorecareful.

BenjaminGrahamaddressedtheissueofriskinhisbookIntelli-

gentInvestor.Hestatesthat“ifagroupofwell-selectedcommon-stockinvestmentsshowsasatisfactoryoverallreturn,asmeasuredthrougha

fairnumberofyears,thenthisgroupofinvestmentshasprovedtobesafe.”15

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Lakonishokandcolleaguesaddressthenotionofriskbyexamining

five-yearreturnstoportfoliosformedineachyearstartingin1968.In

afive-yearholdingperiod,theaveragedifferencebetweenthereturns

ontheextremevalueandglamourportfoliosis84.2percent.16Whatis

alsoremarkableisthatineachfive-yearperiodforwhichthisstudywas

conducted(1968to1985),aninvestorwouldhavebeenbetteroffusing

avaluestrategy.Inotherwords,itdoesnotmatter

whenyoustartonthevalueinvestmentstrategyaslongasyouwaitatleastfiveyearsbeforeyoucomparetheresultsofavalueinvestmentstrategyagainstotherstrategies.Furthermore,Lakonishokandcolleaguesalsoshowthatwhilevalue

investingdoessomewhatbetterduringthedown-marketmonths,itdoes

notdoappreciablyworseintheup-marketmonths.Overall,evidence

showsthatvalueinvestingdoesnotexposeaninvestortoexcessriskin

thelongrun.

Themodernrisk-basedmodelsintheacademicliteratureareunable

toexplainwhyvalueinvestmentstrategiesaresuperiortoothers.The

mostcommonlyusedacademicmodel,popularlyknownastheSharpe,

Lintner,andBlack(SLB)model,describesbetaasthemostappropriate

riskmeasure.AsImentionedbefore,FamaandFrench

showthatthe

resultscannotbeexplainedusingtheriskmeasurebeta.Theystate:“We

areforcedtoconcludethattheSLBmodeldoesnotdescribethelast50

yearsofaveragestockreturns.”

Thereisnoreliableevidence

toprovethatthetraditionalvalue

investingstrategiesareriskierthaninvestinginthestockmarketasa

whole.Valueinvestingyieldshigherreturnsbecausethesestrategiesare

contrariantothebehaviorofthetypicalinvestor.17

Conclusions

Thebasicideabehindvalueinvestingistopurchaseastockatasensiblepriceusingbenchmarkssuchasearnings,assets,dividends,andothers

thatyoumaydevelop.Inaddition,thecompanyshouldbeconservatively

financed.Anumberof

scientificstudiesshowthateventheuseofeasy-

to-followbasicfinancialratioscanrewardyouwell.

Valueinvestingstrategiesprobablyworkbecausesomanyinvestors,

someofwhommayevenstartinvestingaccordingtovalueinvesting

criteria,abandontheirdisciplinedapproachandgiveintotheattractionE1C03

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ofglamourstocks.Thevalueinvestorneedstohavesufficientpatiencetoinvestigatethecompanyandalsotowaitforafewyearsforthestrategy

towork.Manyinvestorsprobablydonothavethepatience.Ifhuman

behaviorisnotlikelytochange,superiorreturnswillcontinuetoflow

tothosewhoinvestbasedonfundamentals,havepatience,anddonot

giveintothelatestfads.So,youhavetoaskyourselfadifficultquestion.

Areyoureallyanydifferentfromtheaveragepersonwhoclaimstobea

valueinvestorbutfailstopracticethebasicprinciples?

Well,areyou?

Date:Jan29,2010

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Chapter4

GrowthInvesting

[T]hegreatestinvestmentrewardcomestothosewho

bygood

luckorgoodsensefindtheoccasionalcompanythatoverthe

yearscangrowinsalesandprofitsfarmorethantheindustryas

awhole.1

—PhilipFisher

WarrenBuffettfreelyacknowledgesthatPhilipFisher’s

teachingsinfluencedhisinvestmentphilosophy.Fisher’s

philosophy,usuallyreferredtoasgrowthinvesting,isbased

onfindingoutstandingcompaniesandstayingwith

themthroughall

thefluctuationsofagyratingmarket.Growthinvestingisinvestingin

stocksofcompanieswhoseearningsareexpectedtogrowatahigher

thannormalrateoveralongtime,notonlyforthenextquarterorthe

nextyear.

Whenpeoplethinkofgrowthstocks,theyusuallythinkofMicrosoft,

Intel,Cisco,andothers.Whilemanyofthegrowthstockscomefrom

high-techindustries,notallofthemdo.Coca-Cola,Wal-Mart,andStar-

bucksarebutafewexamplesofnon-high–techgrowthstocks.Thus,

investinginthehigh-techsectorisnotsynonymouswithgrowthinvest-

ing.BuffettinvestedinCoca-Colawhenitwasmoreofagrowthstock

thanavaluestock.

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Coca-ColaasaGrowth

Attheendof2008,Coca-Colawasthesinglelargestcommonstock

holdinginBerkshire’sportfolio,amountingto16percentofthecommon

stockportfolio.Mostofthepurchasesweremadein1988and1989.At

theendof1988,Coca-Cola’sbookvaluepersharewas$1.07,whereas

thestockpricewas$5.70(splitadjusted),givingitamarket-to-book

(M/B)ratioof5.32.Also,fromtheprice-to-earnings(P/E)perspective,

Coca-Colawasabout35percentmoreexpensivethan

anaveragestock

intheS&P500atthetime(16.8forCokecomparedwith12.4for

theS&P500).PriortoBuffett’spurchase,thestockpricehadgone

up200percentfrom1978to1988.BuffettdidnotbuyCoca-Cola

stockbecauseitwasinexpensiverelativetoitsearningsorbookvalueorbecauseitspricehadfallensignificantlyowingtosomeproblematthe

company.

InTable4.1,IpresentCoca-Cola’searningspershareandbook

valuepersharetoexamine

itshistoricalgrowthbeforeBuffettdecided

topurchasethestock.BecauseoffrequentsharerepurchasesbyCoca-

Cola,thegrowthinunadjustedbookvalueissubstantiallyunderstated.

Toaccountforthis,thelastcolumnpresentsthegrowthinCoca-Cola’s

bookvaluepershareafteraccountingforthecompany’srepurchasesof

itsownshares.

Duringthe10yearspriortoBuffett’spurchase,Coca-Cola’searnings

persharegrewattherateof11.1percent,andbookvaluegrewatthe

rateof10.7percent.Coca-Cola’searnings-per-sharegrowthratewas

impressive:EarningsfortheS&P500firmsinthesameperiodgrew

attherateofonly7.1percent.Therefore,Coca-Cola’searningsgrew

almost50percentfasterthanthosefortheS&P500firms.

Itsstockpricegrewsimilarly,asmentionedearlier.Coca-Colaatthattimealreadyhad

aproventrackrecord,and,obviously,astocklikethatdoesnottradeatalowP/EorM/Bratio.AninvestorwouldbuyastocklikeCoca-Cola

onlyifhewereconvincedofitscontinuedgrowth.

Whenaninvestorbuysastockprimarilybecauseofhisconvic-

tionthatacompanywouldgrowformanyyearsinthefuture,heisa

growthinvestor.Buffett’spurchaseofCoca-Colaseemedtobetheresult

ofagrowthinvestingstrategy.Itworkedoutwell

forBerkshire.Many

investorsandwritersthinkthatwhenvalueinvestingworks,growth

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GrowthInvesting

Table4.1

GrowthinCoca-Cola’sEarningsandBookValueperSharebefore

BerkshirePurchasedtheStock

Growthinbook

valuepershare

Percent

afteradjusting

Percent

growthin

forthe

growthin

valueper

accounting

Earnings

earnings

shareas

valueper

effectsofshare

pershare

stated

repurchases

10-year

average

investingdoesnotwork,andviceversa.Suchmisguidedthinkinghas

comeaboutbecauseofatendencyintheprofessiontodivideagroup

ofstocksintotwo,andonlytwo,categories.Thistypeofmechanical

divisionofagroupofstocksleadstoerroneousinferences.Forexam-

ple,itisnotuncommontodividethe500stocksintheS&P500

indexintotwocategories—valueandgrowth—wherethe

valuecate-

goryincludes250stockswithabook-to-marketratiothatishigherthan

themedian.Theremaining250stocksareputintothegrowthcategory.

Insuchasystem,whenonecategoryoutperformstheoverallindex,

theothercategory,byvirtueofdesign,willunderperformtheoverall

index.

Growthinvestingisharderbecauseitisnotbasedonquantitative

formulassuchastheP/EorM/Bratios.BenjaminGrahampointsto

tworeasonswhygrowthinvestingisdifficult.First,thepricemayalreadyE1C04

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reflectthepotentialgrowth.

Infact,inmostcases,whenthemarketsensesgrowth,thepricegoesupquickly.Inearly2009,evenafterapricedeclineofover30percent,Google’sP/Eratioisabout30.Forthebetterpart

ofthepreviousthreeyears,theratiohasbeenmuchhigher.Second,

theinvestor’sjudgmentofthefuturemayprovewrong.2

However,ifan

investorselectsstocksbasedonanaccurateassessmentofthecompany’s

future,growthinvestingcanbeverylucrative.

HowtoIdentifyGrowthStocks

Wal-Marthasbeenagreatgrowthstock,givingan

80,000percentreturn

overa38-yearperiodsince1970,whensharesfirstbecamepublicly

available,oranincredible35percentperyear.HowdidSamWalton

AccordingtoSamWalton:“Thereisonlyoneboss—the

customer.

Andhecanfireeverybodyinthecompanyfromthechairmanondown,

simplybyspendinghismoneysomewhereelse.”3Thesuccessofabusi-

ness,andhenceitsgrowth,dependsprimarilyonitscustomers.Tofind

agreatgrowthbusiness,youneedtoevaluateitfromacustomer’spoint

ofview.Onceyouaresatisfiedthatthecompany’ssalesandearningswillcontinuetogrowandthatyoucanbuythestockatareasonableprice,

buyandholditforalongtime.

Istartwithhownottoidentifyagrowthstockbecauseitisespeciallyimportantifyouhavebeenconsideringvalueinvesting.Youshouldnot

examinethefinancialfundamentalsimmediatelyafteryouhavediscov-

eredacompanythatmaygrowinleapsandboundsformanyyears.Do

notemphasizethefundamentalsmuch.Inotherwords,whenyoustart

thinkingaboutagrowthstock,donotstartthinkingaboutthehistor-

icalP/Eratioor,forthatmatter,anyotherquantitativemeasurethat

youmighthavelearnedinbusinessschool.Ifyoustart

thinkingabout

traditionalfinancialratios,youwillstartthinkingofvaluestocks,andyouwillprobablyneverpickagreatgrowthstock.Youwouldnever

havepickedsharesinMicrosoft,Wal-Mart,orHomeDepotifyouhad

lookedatthefundamentals

soonafterthecompanieswentpublic.Even

ifyouknewthesewereincrediblecompanies,youwouldhavemissed

theirtremendouspotential.I’mnotsuggestingthattraditionalfinancial

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GrowthInvesting

ratiosarenotimportant;I’msimplysuggestingthatyoushouldnottry

toidentifyagrowthstockusingfinancialratiosalone.

ImportanceofTrack

Record:SalesandEarnings

Themostimportantdriverofgrowthinstockpriceisgrowthinearnings.

Futureearningsgrowthfrequentlydependsonpastearningsgrowth.To

convinceyourselfthatyoumustlookatthetrackrecord,thinkabout

fellowstudentsorcolleaguesatwork.Withhighprobability,youwill

discoverthatstudentswhogetconsistentlygoodgradesforanumberof

semesterscontinuetogetgoodgradesformanymoresemesterstocome.

Similarly,peoplewhodowellinajobcontinuetodo

wellformanyyears

tocome,althoughgoodgradesdonotnecessarilypredictwhowilldo

wellinajob!Thiscorrelationalsoappliestocorporations.Companies

thathavehadpositiveresultsforawhilearelikelytoexhibitthatkindofperformanceforyearsto

come,especiallywhenthemanagementteam

remainsinplace.Onceinawhile,thismaynotwork,butonaverageyou

willcomeoutawinnerifyouplaythegamebyemphasizingacompany’s

trackrecordofearnings.

Ashortrecordof,say,less

thanfiveyearsisprobablyadangerous

waytoidentifythefuturegrowthofacompany.Itisimportanttofocus

onalongertimespan.Greatgrowthcompaniesremainoutstandingfor

manyyearsaftertheirinitialspurtingrowth.Unlessyouknowalot

aboutthecompany,itisbesttoavoidinitialpublicofferings(IPOs).

WhileIPOsareoftenmarketedasgrowthstocks,theirlong-runperfor-

mancehasbeendismal.ProfessorsJayRitterandIvoWelchshowthat

formorethan7,000IPOsmadeover1980through

2005,theaverage

three-yearpost-IPOperformanceis20percentbelowthecorrespondingmarketreturns.4Generallyspeaking,IPOsareanythingbutgrowth

stocks.

Growthinearningsdoes,however,dependongrowthinsales,espe-

ciallyinthelongrun.ImentionedSamWalton’sfocusonthecustomer

becausethecustomeristhemaindriverforgrowthinsales.Ingeneral,

itisbesttokeepbothsalesandearningsinmindwhenthinkingabout

growthinvesting,notjustoneortheother.Onegood

approachtofind-

inggrowthstocksistoidentifysomegreatproductsandservices,asPeterE1C04

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Lynchhasoftenemphasized.Still,youmustaskseveralquestionsbefore

youactuallybuystockinsuchcompanies.Youcanaffordtotakeyour

time.Greatcompanieswillgiveyoureturnsofseveralhundredpercent,

andifyoumisssomeofitinthebeginning,youshould

stilldowell.

Herearesomequalitativequestionsthatyoushouldtaketimetoaskand

answerbeforeyoudecidetoinvestinagrowthstock.

IsTherePotentialtoGrowSalesandEarningsforSeveralYears?

Thisisthemostimportant

question.Youshouldbothertoinvestigate

acompanythoroughlyonlyifithasthepotentialtogrowforseveral

years.Youcouldhaveboughtsharesofanoutstandingcompanysuch

asStarbucksalmostanytimefrom1992to2000forimpressivereturns.

ItseemedclearthatStarbuckswouldcontinuetogrowforalongtime

becausecustomersseemedhighlysatisfied.Ofcourse,wheneitherthe

pricebecomesexcessiveorwhenitisapparentthatgrowthhasslowed,

youshouldsellthestock.

One-timeeventsthathelpgrowcompaniesforashortperiodusu-

allyaffectpricessignificantly,butsuchchangesareoftentemporary.

Inthemid-1970s,againinthemid-1990s,andonceagaininthe

mid-2000swhenoilpriceswentupquickly,many

companiessup-

plyingoil-drillingservicesbecamehigh-growthcompanies.However,

theycouldnotsustaintheirgrowth.Forexample,GlobalMarine,

anotherwisewell-managedcompany,wastradingataround$35per

shareinlate1997,butoilpriceswentdownin1998,andGlobal

Marine’sstockpricequicklyretreatedtolessthan$8pershare.Acarefulinvestorlookingforanoutstandinglong-termgrowthcompanywould

haveavoidedGlobalMarinebecausethegrowthwasfromaone-time

event.

ThisconceptcouldalsobeappliedtotheInternetcrazeofthe1990s.

Atthattime,itwasdifficulttoknowwhichcompanieswouldhave

sustainablegrowth.Unlessyouwereinapositiontodeterminelong-

termgrowthwithsomedegreeofconfidence,youshouldhaveavoided

Internetcompanies.Notethatatthetimeofgoingpublic,evenMicrosoft

wasnotanoutstandinggrowthstockbecauseitwasnotclearthatthe

companycouldsustainitsgrowth.However,overtime,

itbecameclear

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GrowthInvesting

thatMicrosoft’sproductswereimmenselysuccessful,

Microsoftwasa

nearmonopoly,andthenumberofcustomersforthoseproductswould

increaseformanyyearstocome.Atthatpoint,itwasagoodgrowth

stockworthinvestingin.

HowAreRelationswithEmployees?

Goodemployee-managementrelationsleadtohighcustomersatisfac-

tion.Acompanymayhavefineproducts,butunlessthecompany’s

employeesarehappy,customersatisfactionmaydisappearwithtime.A

conversationwiththeemployees—orsomeother

source—wouldreveal

agreatdealaboutemployee-managementrelations.Wal-Martdidnot

succeedonlybecauseithadlowerprices,butbecauseofoutstand-

ingmanagement-employeerelations.In1999,IattendedtheWal-Mart

shareholders’annualmeetinginFayetteville,Arkansas.Joiningmein

attendanceweremorethan10,000Wal-Martemployeeswhoarealso

shareholders.Ihaveneverseensuchenthusiasmfromtheemployees

ofacompany.Theycheeredoftenandendedthemeeting

withthe

well-knownWal-Martcheerthatstarts,“GivemeaW!”Italkedtoa

fewoftheemployeesandrealizedthattheunbelievableenthusiasmwas

genuine.

Theadvantagesofenthusiasticemployeesare

immense:Thecom-

pany’sexpensesarelowerbecauseitsemployeespilferless,customersarehappyandkeepcomingback,andinventorydoesnotstayonshelves

forlong(inventoryturnoverishigh).SamWaltoncalledemployees

“Wal-Martassociates,”and

mostareshareholders.5In2005and2006,

Wal-Mart’smanagement-employeerelationsdeterioratedoveremployee

healthcarebenefits.Thisprobablywasonereasonforadeclineinthe

company’sgrowthin2006.However,Wal-Marthasrespondedvigor-

ouslytocorrectthisproblemandimproveitsimage.

IsResearchandDevelopmentImportant?

Researchanddevelopment(R&D)isneededinallcompanies—notonlyhigh-techones—toimprovetheirproductsandservices.CompaniessuchasMcDonald’sandHomeDepotconstantlyimprove

Date:Jan29,2010

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themselvesthroughcustomersurveys,researchinhumanrelations,mar-

ketresearch,andsociologicalresearch.HomeDepotwouldnotbea

greatsuccessstorywithoutitsresearcheffortsintoimprovingbuilding

materialsoritssurveysofcustomersonthequalityofChristmastree

needles.

R&Dinhigh-techcompaniessuchasMicrosoft,Cisco,andIntelis

clearlyevenmoreimportant,andthesecompaniescan’tsustaingrowth

withoutasignificantR&Deffort.Ifacompanyhasbeensuccessful

becauseofpastR&D,asimplebutmeaningful

questiontoaskiswhetheritiscontinuingthoseeffortsatthesamelevel.Whenthepersonalcomputerindustrywasrelativelynew,anumberofcompanies,including

KayproandCompuAdd,werehighlyprofitablebuthavesincedisap-

peared.Sometimes,companiesarehighlyprofitablebecausethey

copied

othersbutarenotinnovative.Withchangingtechnology,thesecom-

panies’growthfaltersatthenextjunctureofproductdevelopment.

Investorswhoextrapolatepastsalesgrowthintothefuturewithout

understandingtheneedforR&Dtosustainthegrowtharelikelyto

suffer.

YoumightthinkthatcompanieslikeWal-Martdonothavesignif-

icantR&Dexpenditures.Thatisnottrue.Wal-Marthasspentlarge

sumsofmoneydevelopingitshigh-techinventorycontrolsystemsand

oneofthemostup-to-datetransportationnetworks.Determiningwhich

companiesaresavvierinusingtheirR&Ddollarsisadifficulttaskforaninvestor.Merelybecauseacompanyoutspendsothercompaniesin

R&Ddoesnotimplythatitwillbringmoreblockbusterproductstothemarket.TheonlysolutionthatIknowofistoreadaboutthecompany

andlearnasmuchasyoucanfromvarioussources.

AcaseinpointisDellComputer,whichspentsubstantiallylesson

R&Dperdollarofrevenue

thanCompaqandIBM.Dellmaynotdo

basicresearch,butoneshouldnotimmediatelyconcludethatDellisleft

behindinproductinnovation.ThisisbecauseDelldependsmoreon

licensingpatents.Itspendslargesumsofmoneyondevelopmentandto

maintainthebestdirect-to-customermodel.DellhasbeenclosertoWal-

MartinitsbusinessplanthantoCompaqorIBM.MichaelDell’sbook

DirectfromDelldescribesDell’sR&Deffortstokeephiscompany’scostadvantageoverIBMandothers.6Thefocuswasnotonbasicresearch.

InsteadofcomparingR&Dexpensesacrosscompaniesinaneffortto

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GrowthInvesting

pickthebestcompanies,youshouldevaluatethequalitativenatureof

R&Dexpensesandevaluatewhethertheyarekeepingupwithgrowth

inrevenues.

HowDoestheCompanyRespondtoChallenges?

Becauseoftheirculture,

somecompaniesadapttothechangingworld

fasterthanothers.Forsustainablegrowth,itisnecessarythatcompa-

niesrediscoverthemselvesoften.Formostcompanies,itisnoteasy

tochange,andevensomelargefirmsfailwhentheyencounternew

technologies.7

IBMdoesnotselltypewritersanymore.Diditsurpriseyouwhen

IBMsolditspersonalcomputerdivisiontoLenovoin2005?Notme.In

fact,IwonderedwhattookIBMsolong.IBMisnowaone-stopshop

forallsortsofcomputerhardware,software,andservices.Overtime,

IBMhasrediscovereditself.

Wal-Martisanothercompanythatseemstoadapttothetimes.Ini-

tially,itwasonlyadiscountstore.Later,itaddedSam’s,whichisa

buyer’sclub,andthengroceries.Wal-Marthasbeenexpandingoverseas

andishighlysuccessfulinChinaandMexico,butnotinGermany,Japan,

andKorea.InMexico,Wal-Mart’ssubsidiary(Wal-MartdeMexico)has

enteredthebankingindustry,openingbranchesinsideits

stores.Such

venturesdon’talwayshavetobesuccessful,butyouneedtomonitor

themforpotentialgrowth.Wal-Martispushinghardtobeasuccessful

Internetretailingcompany,andIwillnotbesurprisedifitbecomesan

InternetpowerhouseinthefuturetocompeteagainstAmazon.com.

Ifacompanyhasrediscovereditselfafewtimes,itsculturewillproba-

blyallowittocontinuedoingso.Thus,itisnecessarytotakealong-termperspectiveinselectingagrowthstock.Agrowthstockisnotnecessarilyayoung

company.WhentheInternetfirstarrived,Microsoftdidnot

considerittobeanimportantforce.However,Microsoftchangedits

opinionquicklyandremadeitself.Today,itisworkinghardtocompete

withGoogleonInternetsearchandadvertising.

Findingoutwhether

acompanyrediscoversitselfoftenrequiresaconsiderableamountof

research.Financialratiosjustdon’tcapturethesequalitativeaspectsofgrowthcompanies.However,theseeffortsarenecessaryifyouwantto

discoveroutstandinggrowth

companies.

Date:Jan29,2010

Time:12:58pm

IsManagementQuality

Excellent?

PhilipFisher’sapproachisprobablythebestforjudgingthequalityofacompany’smanagement.Hesuggestsposingquestionstothecompany’s

consumers,suppliers,andemployeestogetagoodsenseofthequalityof

itsmanagement.Itisnot

impossibletodiscernthatWal-Mart,Google,

andSouthwestAirlineshaveexcellentmanagement.Also,eachyearFor-

tunepublishesalistoftheworld’smostadmiredcompaniesandBarron’spublishesalistoftheworld’sbestCEOs.Youmayknowsomeofthe

companiesinsuchlistswellandselectthemforfurtherinvestigationforinvesting.

Tomeasurethecommitmentofacompany’stopmanagement,find

outwhethertheseniormanagersowncompanysharesandwhetherthey

keepthesharestheyareawardedaspartoftheir

compensation.Ifthe

seniormanagersofacompanyselltheirsharessoonafterthesharesare

awardedoraftertheyexercisetheirstockoptions,youneedtoinvestigatethecompanycarefully.

Whyaresomemanagementteamsbetterthanothers?Idonot

claimtoknowtheanswertothisquestioninmostcases,buthereis

athought.EveryyearIaskgraduatingstudentsabouttheirpreferences

forthecompaniestheywouldliketoworkfor.Ithasalwaysamazed

mehowknowledgeableyoungpeopleare.Inthelate

1990s,thecom-

panyofchoicewasMicrosoft.Inthelate2000s,itisGoogle.Ifstudents,especiallytalentedones,chooseGoogleoverMicrosoft,thenGoogle’s

managementculturewill,overtime,changetoreflectthequalityofthe

peopleitemploys.Not

surprisingly,varioussurveysrevealthatmanyof

thesamecompaniesareidentifiedashavinggoodmanagementtimeand

againoveranumberofyears.Sincehigh-qualitymanagershavepridein

theircompaniesandthemselves,theyarelikelytotakestepstomaintain

thecompany’sreputation.

Hereisonemorecluetomanagementqualityorlackthereofthat

comesdirectlyfromBuffett’sprincipleofcirclesofcompetence.Whena

retailcompanyappointsanewCEOwithoutretailexperience,itraises

aredflagabouthisorherpotentialeffectiveness.Suchincongruous

appointmentsarecommon.Tothebestofmyknowledge,CEOsinBerk-

shiresubsidiariesallhaverelevantexperienceandenvioustrackrecords.

Avoidcompanyfinancialstatementsandother

documentstodecipher

Date:Jan29,2010

Time:12:58pm

GrowthInvesting

managementquality.Accordingtocompany

reports,allmanagersare

excellent!Thus,itisimperativetolookatothersourcesforinformationonmanagementquality.

HowImportantAreProfitMargins?

Whenprofitmarginsarehighandcanbemaintainedatthatlevel,growth

insaleswillproducebetterandbetterresultsasthecompanygrows.Oth-

erwise,growthinsaleswillnotbehighlyvaluable.AsPhilipFisherpointsout:“Allthesalesgrowthintheworldwon’tproducetherighttypeof

investmentvehicleif,overtheyears,profitsdonotgrowcorrespond-

ingly.Thefirststepinexaminingprofitsistostudyacompany’sprofit

margin.”8

Excellentgrowthcompaniesalmostalwayshavehighprofitmargins

relativetootherfirmsinthesameindustry.Forexample,onemight

assumethatWal-Martprobablyhassmallerprofitmarginsthanitscom-

petitorsbecauseitiswellknownforlowerprices.ThatisonereasongivenforKmart’slossofmarketsharetoWal-Martandfinallygoingbankrupt

in2002.YoumaybesurprisedtoknowthatWal-Mart’sprofitmargins

werehigher:3.4percentversus1.8percentbeforeKmartwentbankrupt.

Anexcellentcompanyrarelycompetesonpricealone.Thereareusu-

allyotherreasonsforitsexcellence.Myanalysisledmetobelievethat

Wal-Mart’shighprofitabilityispartlyduetoitsfocuson

highinventoryturnover.

Itisoftenarguedthatcompanieswithhighprofitmarginsattract

competition,andthus,theirhighprofitmarginswillultimatelygoaway.

Thetruthisnotthatsimple.Companieswithhigherprofitmarginscan

alwaysreducetheirpricestodrivethecompetitionawayandstillremain

profitable.WhilecompetitorssuchasAdvancedMicroDevicestryto

copyIntel’sproductstocompeteonprice,Intellowersthepriceofits

older-generationproductsandmovesontohigher-

marginproducts.In

theory,itispossibleforcompetitorstoultimatelycatchupwithIntel,

butitappearstomethat,inpractice,itismoredifficultthanitappearstoanunconnectedparty.Howcananothercompanyeasilycompetewith

amarketleaderand

innovatorlikeIntel,whichishighlyprofitableand

hasdeeppockets?Thecompetitionmustalsothinkofthepossibilityof

losingbillionsofdollars,notbeingabletocompete,andpossiblyeven

Date:Jan29,2010

Time:12:58pm

goingbankrupt.Overall,high-profit–margincompaniesusuallyfallin

thegrowthcategory.

WhatIstheCompany’s

Achilles’Heel?

Withmanypotentialvariablestoexamine,Idonotrecommendthat

youusealonglistofvariablestoevaluateacompany’sgrowthprospects.

Howaboutlookingatacompanyfromanotherperspective?Whereis

theAchilles’heel?Thiswillhelpyoutonotfallinlovewiththestock.

Ifthesituationdeteriorateswithrespecttotheimportantvariables,youwillbeabletosellthestockbeforeitistoolate.Ifyoufallinlove,yousometimesmissthecuestosell.

Once,onaYahoo!chatboard,IaskedwhatBerkshire

Hathaway’s

Achilles’heelcouldbe.ThemostfrequentanswerwasBuffett’sage(77

in2007whenIaskedthequestion).Thequestionisclearlyanimportant

one.WithoutWarrenBuffett,willthestockpricetumble?Inmostcases,

whentheCEOofagreatcompanyretiresorresigns,thereisavacuum

atleastforawhile.AfterSamWaltondied,Wal-Mart’sstockpricewas

stagnantforatime.However,thecompanyremainedstrong;andfinally,

aftertwoorthreeyears,thecompanyresumedapathof

growth.

OneExampleofaNon-TechnologyGrowthStock

Thereareinnumerableexamplesofnon-high–techgrowthstocks,and

dependingonyourskills,background,andcommitmenttoacquire

knowledge,youshouldbe

abletofindsomeoftheminthefuture.Recent

examplesareWal-Mart,HomeDepot,Starbucks,Chipotle,Danaher,

andEatonVance.However,inthissection,wearegoingtodiscussone

specificexampleofanon-technologygrowthstock:McDonald’s.

In1980,McDonald’sstockpricewasabout$1pershare(split-

adjusted)comparedwithitspriceofabout$45persharein2000.On

average,thestockpricerosebymorethan20percentperyearorabout

twiceasfastastheoverallmarket.Evenifyouboughtit

in1990atabout$7pershare,youwouldhaveenjoyedatleastasixfoldincreaseinthe

stockpriceby2000.

ThequestionbecomeswhetheryoushouldhaveboughtMcDonald’s

commonstockin1990afterthecompanyhadexperiencedphenomenal

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Time:12:58pm

GrowthInvesting

growth.Overthepriorfiveyears,theearningspersharegrewatasteadyrateofabout14percentperyear,from

$0.28in1985to$0.55in1990.

McDonald’swasexpandingoverseassuccessfully.So,apersonwitha

goodknowledgeofthefast-foodindustryandMcDonald’swouldhave,

Ibelieve,surmisedthatearningswouldcontinuetogrowsteadily.The

earningspersharegrewfrom$0.55in1990to$1.40in1999.

WhenyouidentifyacompanysuchasMcDonald’sthathasgrown

steadily,youneedtofollowupbyaskingwhetherthecurrentpriceisreasonable.Inmydiscussion,IamnotincludingIPOs,tinycompanies,or

othercompaniesthataredifficulttovalue.TheP/EratiosofstockslikeMcDonald’saregenerallyhighinrelationtotheirhistoricallevelsorthemarket,andtheyremainhighforlongperiods.Youshouldnotimmediatelyconcludethatthestockisexpensiveandthatyouhavemissedthe

boat.Itisuncommonforagrowthstocktotradeatalow

P/Eratio.

Thestockisstillworthbuyingaslongasthepriceisnotastronomical,

sayabove25or30timesearnings,andyouareconfidentaboutfuture

growth.OnlyinrarecasesdostockstradingaboveaP/Eof30generate

highreturnsoveralongperiod.

By2000,McDonald’sP/Ewas32.AP/Eof32washighincontrast

toitsmedianP/Eofabout18intheprior10yearsorthelong-run

S&P500P/Eofabout16.Thisiswhenknowledgeofthefirmbecomes

important.Itwasstillagoodcompanyandwasexpectedtogrow,albeit

ataslowerrate.Itwasjustnotagoodtimetobuy.

Fromaninvestingpointofview,onethingyoucandoistowait

foropportunitiesingoodgrowthstocksonceyouidentifythem.With

McDonald’s,youwouldhavedonewellifyouhadinvestedin2003

whenthestockhitalowofabout$13pershare,primarilybecauseof

anoutbreakofmadcowdiseaseintheUnitedKingdomandisolated

placeselsewhere.TherumorsofthedemiseofMcDonald’s

provedtobe

wrong.Whatabargaingrowthstockitwas!In2009,itsstockpricewas

around$53pershare.

Conclusions

Tofindapromisinggrowthstock,Irecommendthatyoustartbyexamin-

ingearningsforseveralyearsbecausecompaniesthathavegrownstrongly

Date:Jan29,2010

Time:12:58pm

forseveralyears,onaverage,aresoundcandidatestogenerategoodearn-

ingsinthefuture.Youalsoneedtoexaminequalitativevariables,such

asthequalityofmanagementandcompanyculture,astheyarethetrue

underpinningsoffuturegrowth.Beforeyoubuya

growthstock,you

shouldconsiderthepossibilitythatthepricemayalreadybereflecting

ahighgrowthpotential.YoumaydosobyevaluatingitsP/Eratioor,

preferably,computingitsintrinsicvalueasIdiscussinthenextchap-

ter.Overall,successingrowthinvestingrequiresyoutohaveavery

goodknowledgeofthecompany’sbusinessandanabilitytoforecastits

earningswell.

Date:Feb4,2010

Time:2:29pm

Chapter5

IntrinsicValue

Ingeneralterms,it[intrinsicvalue]isunderstoodtobethat

valuewhichisjustifiedbythefacts,e.g.,theassets,earnings,

dividends,definiteprospects,asdistinct,letussay,frommarket

quotationsestablishedbyartificialmanipulationsordistortedby

psychologicalexcesses.1

—BenjaminGrahamandDavidDodd

Beforeyouriskyourhard-

earnedmoneyonastock,youprobably

wanttoknowthevalueyoucanexpecttogetinreturn.The

valueyouassigntoastock,orthatstock’sintrinsicvalue,isthemaximumamountthatyouarewillingtopaynowforfuturebenefits,

whichcouldcomefrom

dividendsorthepotentialsaleofthestock

atarealisticfutureprice.Itmakesnosensetobuyastockwhenits

intrinsicvalueissmallerthanthecurrentprice.Buffettcautions:“The

calculationofintrinsicvalue,though,isnotsosimple...intrinsicvalueisanestimate

ratherthanaprecisefigure.”2Inthischapter,IcomputetheintrinsicvalueofWescoFinancial,Coca-Cola,andBerkshireHathaway

tomorethoroughlyexplainthisconcept.

ComputingIntrinsicValue

Individualsdifferfromoneanotherinassessing

companies’future

prospects.Theyalsodifferintheirrisktolerance.Hence,itshouldbe

Date:Feb4,2010

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nogreatleaptoacceptthatthereisnouniqueintrinsicvaluethatcan

beassignedtoacommonstockuponwhicheveryonewillagree.In

computingintrinsicvalue,

youshouldstartbyexaminingacompany’s

balancesheet.Someassets,suchascashandinvestmentsinmarketable

securities,arereportedatmarketvalue.Asafirstapproximation,the

intrinsicvalueofsuchitemscanbetakentobethesameastheirmarket

values.Formostcompanies,however,themajorcomponentofintrinsic

valuecomesfromtheirfutureearnings.

Forvaluationoffutureearnings,youcanstartwithestimatinga

growthratebasedonyourevaluationofthecompany’spastperformance.

Thenyoucanapplytheestimatedgrowthratetocurrentearningsto

approximateexpectedearningsforafutureyear,say,10yearsfromthe

currentyear.Finally,applyaP/Emultipletothefutureearningsper

sharetoestimatethevalueofthoseearningsinthefuture

anddiscount

themtotheirpresentvalue.Inaddition,dividendsshouldbeproperly

accountedfor.

Whileitisasimpleapproach,itrequiresmanyassumptions.For

example,youmayhavetoadjustreportedearningsinan

attemptto

obtainunderlyingorsustainableearnings.Youalsoneedtoassumea

growthrate,aP/Emultiple,andadiscountrate.Withthisapproach,it

isimportanttoknowthecompany’sbusinesswellforyoutocomeup

withreliableestimates.

Let’sexaminethreeexamplesofevaluatingcommonstocks.The

firstone,Wesco,iseasytoevaluatebecausemostofitsassetsarein

marketablesecurities.EarningsplayalimitedroleinWesco’sintrinsic

value.Incontrast,Coca-Cola’svalueisdrivenprimarilybyitsearnings.

Finally,IpresentanapproachtoestimatingBerkshire’sintrinsicvalue.

Wesco:FocusontheBalanceSheet

WescoFinancialCorporationisan80.1percentsubsidiaryofBerkshire

Hathaway.CharlieMunger,vicechairmanofBerkshireHathawayand

chairmanofWesco,hasestimatedtheintrinsicvalueofWescoinselected

prioryears.Thisanalysisfollowshisargumentsusingdatafromthe2008

annualreport.

Table5.1presentstheWescobalancesheetinasummaryform.

Wescohastotalassetsof$3,051million,ofwhich$298million,roughly

Date:Feb4,2010

Time:2:29pm

IntrinsicValue

Table5.1

WescoFinancialCorporationBalanceSheet,

December31,2008

Assets

Cashandcashequivalents

Investments

Marketableequitysecurities

Securitieswithfixedmaturities

Otherassets

Totalassets

$3,051

LiabilitiesandShareholders’Equity

Liabilities

Float(Insurancelossesnotyetpaid)

Incometaxespayable,deferred

Otherliabilities

Totalliabilities

Shareholders’equity

Totalliabilitiesandshareholders’equity

$3,051

Dollaramountsinmillions.

10percent,areincashandcashequivalents.Themarketablesecurities

of$1,868millionareprimarilyinProcter&Gamble($386million),

Coca-Cola($326million),WellsFargo($373million),andKraftFoods

($269million).Thus,mostofWesco’sassets(cashandcashequivalents,

securitieswithfixedmaturities,andinvestments

of$298million,$29

million,and$1,868million,respectively),amountingto$2,195million,

arereportedatmarketvaluesandmaybeconsideredliquidassets.

Weshouldsubtractliabilitiesfromtheseassetstotheextentthey

arerelatedtotheassets.Ontheliabilitiesside,totalreportedliabilitiesare$673million.Thereareonlytwomeaningfulitemsthataredirectly

relatedtoinvestments:thedeferredincometaxespayableof$231million

andthefloatof$215million.Botharenon-interest–bearingliabilities.

ThefirstamountispayabletotheIRSonlywhenthesecurities(suchas

Procter&Gamble)aresold.Thus,itisessentiallyaninterest-freeloanfromtheIRStoWesco.Youneedtoestimatethetruevalueofthis

Date:Feb4,2010

Time:2:29pm

liability.Ifyouassumethatthesesecuritieswillnotbesoldforalongtime,thetaxeswillalsonotbepaidforalongtime.Then,mostofthis

liabilitymaybeignoredfor

valuingWesco.Thus,thetruevalueof

theliabilityissomewherebetweenzeroand$231million.Iassumethe

trueliabilitytobe$115million,halfwaybetweenzeroand$231million.

Thesecondliability,float,isthetermformoneythecompanyholds,andaslong

asinsuranceunderwritingresultsarebreak-even,itcoststhecompanynothing.Iassumethatthecompanywillnothavetopaythis

floatforanyforeseeablefutureandmayevengeneratesomeincomefrom

thefloat.Thus,Iwillassumethatthefloatfromtheinsurancebusiness

isessentiallyfree.Subtractingtheliabilityof$115millionfrom$2,195

millionequals$2,080millionasanestimatedvalueofliquidassets.

IfWescodidnothaveanyoperatingsubsidiaries,wecouldstophere.

Wesco’stotalnetincomefor2008was$82million.Outof

this,$64mil-

lioncamefrominvestments,andtheremaining$18millioncamefrom

operatingbusinesses.Havingalreadyassignedavaluetotheinvestments,

weshouldconsideronlytheremaining$18million.Anexamination

oftheearningsoverthepastfewyearssuggeststhattheseearningsare

sustainable,asearningshavebeensimilarinrecentyears.BecauseWesco

hasnodebtandearningsarelikelytoremainatleastatthisleveland

possiblygrow,Iuseasimpleapproachtovaluethese

earnings.Iassign

aP/Emultipleof15thatresultsinavaluationof$270millionforthe

operatingbusinesses.So,myestimateofintrinsicvalueofWesco’scom-

monstockis$2,080million+$270million,or$2,350million.Based

onthenumberofsharesoutstanding(7.12million),thistranslatesinto

anestimatedintrinsicvalueof$330pershare.Incomparison,themarket

priceattheendof2008was$288pershare.Notethatwemadesev-

eralassumptions,andourestimateofintrinsicvalue

wouldchangeifwe

usedadifferentvaluationforthefloatfromtheinsurancebusiness,the

estimatedP/Eratio,orthevaluationofdeferredtaxes.Ourestimateof

intrinsicvalueisclosetothebookvaluepershareof$334reportedby

thecompanyattheendof2008.3

YouhavesurelynotedthatWesco’sintrinsicvaluedependsaloton

thevaluationofitsinvestments—thatis,themarketpricesofProcter&Gamble,Coca-Cola,WellsFargo,andKraftFoods.Asafirstapproximation,wehaveusedmarketvaluesofthese

investmentsasifthey

representtheirintrinsicvalues.Foramoreelaborateevaluation,youmayE1C05

Date:Feb4,2010

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IntrinsicValue

considercomputingintrinsicvaluesoftheseholdings.Rememberthat

theintrinsicvalueisanestimate—evenmoreimportant,itisjustone

person’sestimate,whichcanvarywidelyacrossindividuals.Inthiscase,myestimateof$330wasnotvastlydifferentfromthemarketpriceof

$288pershareattheendof2008.So,Wescowasnotabuy.

Coca-Cola:FocusonEarnings

UnlikeWesco,Coca-Coladerivesitsvaluefromitsearnings.Inthe

caseofWesco,wedidnotemphasizegrowthinearnings.Coca-Colais

different,anditpresentsagoodexampletodiscussgrowthinearnings.

Iwilluse1998asthebaseyearforthispurposebecauseitgivesusan

opportunitytolookatdevelopmentssincethen.

Attheendof1998,Coca-Cola’stotalassetsof$19.14billionwere

mostlyrepresentedbytangibleassets.Thecompany’sliquidassetsinthe

formofcashandmarketablesecuritieswereonly$1.81billion.An11-

yearhistorydetailedintheannualreportshowedthatCoca-Cola’scash

andmarketablesecuritiesin

1998,atabout10percentofrevenues,were

inlinewithhistoricallevels.Also,theywerelessthan1percentofthemarketvalueofthecompany’sshareholders’equity.Therefore,weneed

nottreatthemseparatelyaswedidforWesco.Iassumethatthismuch

cashandmarketablesecuritiesareneededtorunthecompany.

Thenextstepistothinkmoreclearlyaboutgrowthprospects.In

the10yearsbefore1998,Coca-Cola’srevenuesgrewattherateof8.8

percentperyear,anditsearningspersharegrewat

14.5percentperyear.

However,intheimmediatelyprecedingfiveyears,thegrowthinrevenues

hadslowedto6.0percent,andearningspershareto11.2percent.

Thecompany’searningsfor1998were$1.42pershare,which

seemedsustainablebecauseearningspershareforthepriorthreeyears

weresimilar:$1.67,$1.40,and$1.18,respectively.Itseemedreasonable

toestimatethefuturegrowthinearningstobe10percentperyearfor

thenext10years,whichwasclosertothepreviousfive

years’growth

inearnings.Underthisassumption,in10years,expectedearningsfor

2008(basedondatain1998)wouldbe$3.68pershare.Next,weneedto

estimateareasonableP/Emultipleforearningspersharefor2008.For

alow-debt,well-managedcompany,aP/Emultipleof15to20appears

reasonable.However,forthepurposeofthiscomputation,let’susea15

Date:Feb4,2010

Time:2:29pm

P/Emultiplethatgivestheexpectedvalueofearningsattheendof2008

as15×3.68,or$55.20pershare.

Thepresentvalueof$55.20dependsonthediscountrate

assumed.

IthinkofthediscountrateastheminimumrateatwhichIwouldbe

comfortableowningapartofthecompany’sbusiness.Thediscounted

valueof$55.20in1998atthediscountrateof7percent(alowrate,

butanassumptionbasedonthemortgagerateIwaspayingatthetime)

is$28.06pershare.IfCoca-Colawasnotpayinganydividends,that

wouldbeoneestimateoftheintrinsicvalueofCoca-Colaattheend

of2008(orinearly1999when1998year-end

accountingdatabecame

available).

Weshouldaddthevalueofdividendsatleastfortheamounts

expectedtobereceivedduringthefollowing10years.Thecashdiv-

idendin1998was$0.60pershare.Assuminga10percent

growthrate

individends(similartothegrowthrateinearnings),aninvestorwould

havereceived$0.66in1999,andsoon.Usingadiscountrateof7per-

cent,thediscountedvalueofthenext10years’dividendsis$9.83per

share.Therefore,myestimateofCoca-Cola’sintrinsicvaluein1999was

$28.06+$9.83=$37.89.

Inthefallof1999,whenImadethesecalculationsinaclassIwas

teaching,thestockpricewasabout$70pershare.Basedonthesecalcula-

tions,Coca-Colastockseemedovervaluedbyalmost100percent.Note

thatweestimatedthatinearly2009,theCoca-Colastockpricewould

bearound$55.20pershare.Inearly2009,theCoca-Colastockprice

was$45pershare;andtheP/Emultiple,basedon

trailing12months’

earnings,was18.

Youcanaddmanyotherchangesandcomplications.Forexample,

youcouldarguethatweshouldvaluedividendsdifferentlyfromearnings

becausedividendsarebeingpaidoutwhileearningsare

not.Youcould

havesimplyusedthedividenddiscountmodelgenerallyattributedto

MyronGordon.4Overall,dependingonassumptions,youcouldhave

producedsubstantiallydifferentestimatesofCoca-Cola’sintrinsicvalue

inearly1999.

Afewadditionalcommentsontheanalysisareworthmaking.Coca-

Colaisastablecompany,soitisrelativelyeasytoestimatefutureearnings.

Thepossibilityofyougoingverywrongislow.Giventhattherearefar

toomanyuncertaintiesforhigh-techcompanies,youshouldthinkmore

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IntrinsicValue

carefullyabouttheirfutureearningsbeforeyoucomputeintrinsicvalue

inasimilarmanner.

EvenCoca-Cola’sstockpricefluctuatedbyafactoroftwobetween

1998and2009.Ithasseenalowoflessthan$40pershareandahighof

morethan$85pershare.Soifyoudonothavealong-termviewanddo

nothavesufficientliquidity,youmaynotachieveyourgoalofreasonablereturnswithanycompany’sstock.Forexample,ifyousuddenlyneed

fundsandarerequiredtosellwhenthepriceislow,youmightlosea

substantialamountofyouroriginalinvestmentevenifyouinvestinCoca-

Cola,letaloneinstocksofcompanieswithlesspredictableearnings.

Thereisanotheradvantagetocomputingintrinsicvalue.Itkeepsyou

groundedsothatyoudonotbecomenervouswhenthe

stockpricegoes

down.Asamatteroffact,IconsideredbuyingCoca-Colastockwhen

thesharepricewasaround$40,downfrom$85.ButIdidnotbecause

intrinsicvalueestimatesstilldidnotjustifybuying.

Acheck:WhileIwas

assigninga15to20P/EmultipletoCoca-

Cola’sstock,IwonderedwhytheP/Emultipleinearly1999was

$70/1.42,orabout49.Itcouldhavebeen25oreven30,butwhy

didthestockcommandahighP/Eof49?Aroundthen,themarket

wasassigninghighvaluationsnotonlytoCoca-Colabutalsotoahost

ofotherstocks,especiallyInternetstocks.Thesestockswereboatsthat

werebeingliftedinarisingtide.Whatcanwelearnfromthis?Youcouldsay,“Themarketwaswrong,”butforme,unfortunately,thatisnevera

satisfactoryanswer.Iwouldask,“Whywasthemarketwrong?”Isimply

donothaveasatisfactoryanswertothequestion,“WhywasCoca-Cola’s

stockpricesohigh?”Nevertheless,whenitdoeshappen,itisbestnot

tobuy.

BerkshireHathaway:IntrinsicValue

Let’scomputeBerkshire’sintrinsicvalue.BuffetthasneverfurnishedhisestimateofBerkshire’sintrinsicvalue,norhashesuggestedawell-definedapproach.However,hehasfrequentlydiscussedvariousinputsthatmay

beconsideredbyinvestors.

MyapproachisbasedonBuffett’srecent

hintsonhowtocomputeBerkshire’sintrinsicvalue.Asmentionedin

thepreface,myobjectivehereistolearnasmuchaswecanfromBuffett’swritings.

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Table5.2

BerkshireHathawayDataforItsValuation

Per-share

Pretaxearningspershare

investments

(noninsurancebusinesses)

$50,648

47,460

52,705

62,273

66,967

74,129

80,636

90,343

77,793

2000–2008compounded

growthrate

23.10%

Onewaytocomputeintrinsic

valueistostartbyestimatingexpected

futurecashflowsthatcanbetakenoutofabusiness.Ifcashflowsare

nottakenoutofthebusiness(asinthecaseofBerkshire),theyresultinadditionalgrowth.Wecanthenextrapolatepastgrowthintothefuture

withanyadjustmentsthatwedeemappropriate.InthecaseofBerkshire,

cashflowsultimatelyendupinoneoftwoplaces.

1.Investments,suchasstocks,bonds,andcashequivalents.These

includeequityinvestmentsAmericanExpress,WellsFargo,etc.

2.Purchaseofmajority-ownedorfullyownedsubsidiariessuchas

DairyQueen,NetJets,etc.

Byvaluingthesetwoitems,wecanvalueBerkshire.Tovaluethe

investments(item1),wewillusetheirmarketvalues.Tovaluesub-

sidiaries(item2),wewillusetheirearnings.Buffetthasperiodically

givennumbersforboththeseitemsinBerkshire’sannualreports.Let’s

examinethehistoricalperformancefromTable5.2.

1.Berkshire’sinvestmentspersharegrewfrom$50,648in2000to

$77,793in2008,acompoundedgrowthrateof5.5percentper

year.Fortheperiod1995to2006,Buffettreportsthegrowthtobe

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IntrinsicValue

12.6percent.Thelowerrecentgrowthprobablyreflectsadditional

investmentsinfullyownedsubsidiaries,theincreasingsizeofthe

company,andespeciallythemarketcrashof2008.

2.Thepretaxearningsofnoninsurancebusinesseshavegoneupfrom$848persharein2000to$3,921persharein2008.5Thisgrowth

rateinearningsamountsto21percentperyear.Fortheentireperiod

from1965to2008,thecompoundedannualgrowthratewasabout

17percent.Therecenthighgrowthinearningsisprimarilydueto

acquisitions,asBerkshire’sfocusshiftedtowardusingmorefreecash

flowsforthispurpose.Undertheassumptionthattherecentpattern

ofusingcashflowswillcontinue,wewillapplythe

growthrateof

21percenttoestimatefutureearnings.

Let’sconsiderwhatthecompanywilllooklike10yearsfromnow.

RecallthatwedidnotusesuchprojectionsincomputingWesco’sintrin-

sicvalue,asitdidnotseem

importantanditwasnoteasytodoso.InthecaseofBerkshireHathaway,thereareatleastthreequestionstoconsider.

rIsthegrowthrategoingtobesmallerorhigherthanthepercentages

wejustcomputed,orthesame?

rHowlongisthegrowthrate

goingtolast?

rFinally,whatdiscountrateshouldweuse?

Ididn’tseeanythinginthevariousannualreportsthatsuggeststhat

weshouldnotusethecompany’srecentgrowthrates,solet’suse5.5

percentforinvestmentsper

shareand21percentforearningsofnonin-

surancebusinesses.The5.5percentgrowthrateforinvestmentsappears

lowandthe21percentgrowthratefornoninsuranceearningsappears

high,butyoucanalwaysusedifferentratesandgetdifferentintrinsic

valueestimates.Alsonotethatiftherearenonewacquisitionsforgrowth,Berkshire’scashflowswillbeusedtowardahighergrowthininvestments.

Asbefore,Iwillusethediscountrateof7percentfordiscountingfuturevaluestocomputethecurrentintrinsicvalueestimate.6

Basedontheseassumptions,

10yearsfromnow—thatis,attheend

of2018—thevaluesareexpectedtobeasfollows:

Investmentspershare:

$132,882

Pretaxearningspershare:

$26,379

Date:Feb4,2010

Time:2:29pm

Let’svalueinvestmentspershareattheirreportedvalueof$132,882

becausetheyareessentiallyatmarketvalue.Forearnings,IuseaP/E

multipleof10onpretaxearnings(whichisequaltoamultipleofabout

15onafter-taxearnings).Ifwedothat,wegetaper-sharevaluationof

Berkshire’scommonstock,classA.Theestimatedvalue

10yearsfrom

nowis$132,882+10(26,379)=$396,672.Thepresentvalueofthis

dependsonthediscountrateyouuse.Witha7percentdiscountrate,

thatgivesapresentvalueof396,672÷1.97,or$201,356.

Wearealmostthere.Similar

toourapproachtoWesco,ifweassume

thatthecostoffloatiszeroandusehalfthedeferredtaxliabilityamount,weendupsubtractingabout$3,300persharefrom$201,356.Rounding

itoff,myestimateofBerkshire’scurrentintrinsicvalueis$198,000pershare.

Wow!ItseemsthatBerkshirewasundervaluedatthetimeofthis

analysisinearly2009asthemarketpriceofthestockwasaround$90,000

perclassAshare.So,Berkshirestockwasabuyandremainssoin

November2009,withthestockpricearound$100,000.

ThiscomputationdoesnotimplythatBerkshire’sstockpriceislikely

tojumpintheshortrun.Itisdifficulttoknowhowandwhenpriceswillreflectvalueevenifmyestimatesarecorrect.Idon’tknowhowother

marketparticipantsarethinkingandvaluingBerkshire.Thisisjustmy

estimate.Asearningsgodownin2009becauseofrecession,itwillnot

surprisemeifBerkshire’sstockpricegoesdownorremainsaboutthe

sameintheshortterm.However,let’sexaminewhatthefuturevalues

implyintermsofexpectedreturns.Ifyoupurchasea

BerkshireclassA

shareat$90,000,theimpliedrateofreturnis16percentperyearifthestockpricedoesreach$396,672.

Acheck:Let’susethedatafrom2006and2007toexaminethevalid-

ityofthisapproach.For2006,theinvestmentspersharewere$80,636,

andthepretaxearningspersharewere$3,625.Ignoringadditional

minorestimates,thisgivesusaper-sharevalueof$80,636+10(3,625)

=$116,886.Inearly2007,whenthe2006annualreportbecameavail-

able,thestockpricewasabout$110,000.Somaybe

ourmetricisslightly

generousinvaluingBerkshirecommonstock.Butitisnotdramatically

differentfromthepriceinthemarket.Usingthesamemetricfor2007

data,anestimatedintrinsicvalueinearly2008is$90,343+10(4,093),or$131,273.Thestockpricein

early2008was$140,000.Berkshire’sstock

Date:Feb4,2010

Time:2:29pm

IntrinsicValue

pricesmoveconsiderably

withthemarketbecauseofitslargeinvestments

incommonstocks.

WhentoBuyAnyStock:

ConsiderMarginofSafety

Wecomputedintrinsicvaluesofthreecompanies,andweknowthata

stockshouldbepurchased

onlyifthemarketpriceisbelowthestock’s

intrinsicvalue.Aquestionthatyoumustaskis:“Howmuchlowershouldthepriceberelativetotheintrinsicvalue?”Ithinkofmarginofsafetyforanystockasthedifferencebetweenastock’sintrinsicvalueanditsmarketprice.Ifyoubuyastockatitsintrinsicvalue,youwillhavenomargin

ofsafety.Ifeverythinggoesasyouassumeinyourcalculations,youwillearnanannualrateofreturnequivalenttothediscountrateassumed.

Forexample,ifyouassumeadiscountrateof7percentaswedidinthe

examplesandpurchasethestockatintrinsicvalue,yourannualrateof

returnwillbe7percent.Ifthesamestockispurchasedat25percent

belowtheintrinsicvalue,thecalculationsshowthattherateofreturn

willbeabout10percentperyear.Andifthestockisathalftheintrinsicvalue,therateofreturnwillbeabout15percent.Soitseemslogicalthatyoushouldbuya

stockwithalargemarginofsafety.Analternatewayof

thinkingaboutlookingforalargemarginofsafetyistorequirealarge

discountrate.

Afewpointsyoushouldbefullyawareof:First,incomputations

ofBerkshire’sintrinsic

value,investmentspersharearebasedonmarket

prices.Asthemarketgoesupordown,thevalueofinvestmentsper

sharewillchangeaccordingly.Iftheunderlyingstocksareoverpricedor

underpriced,theintrinsicvaluewillalsobebiased

upwardordownward.

Second,wereliedonoperatingearningsofnoninsurancesubsidiariesto

growattherateof21percent.WiththeNovember2009announcement

oftheBurlingtonNorthernSantaFeacquisition,thegrowthratein

earningsisnowmorelikelytobeaccomplished.

Giventhattherearemanyassumptionsinvolvedinthisprocess,you

shouldcomputedifferentnumbersbasedonthoseassumptions.The

proportionyouinvestinanindividualstockshoulddependonitsmargin

ofsafetyandyourconfidenceinyourcomputationofitsintrinsicvalue.

Date:Feb4,2010

Time:2:29pm

Finally,youshouldlearnaboutthemanagement.IfyouhaveaBuffettor

Mungertypeonyourside,asmallermarginofsafetyshouldbeadequate.

Conclusions

Thischapterisdevotedtoexplainingthemethodologybehindestimating

theintrinsicvalueofacommonstocktoprovideyouwithaguidelinefor

abuyorselldecision.Itisimportanttolearnalotaboutthecompanysothatyoumayconsideranappropriatemethodforcomputingitsintrinsic

value.Youshouldinvestonlywhenthemarginofsafetyishigh.

Date:Jan29,2010

Time:1:14pm

Chapter6

BuffettInvesting=

Value+Growth

[M]ostanalystsfeeltheymustchoosebetweentwo

approaches

customarilythoughttobeinopposition:“value”and“growth.”

...Inouropinion,thetwoapproachesarejoinedatthe

hip:Growthisalwaysacomponentinthecalculationof

value.1

—WarrenBuffett

MostpeoplecharacterizeBuffettasavalueinvestor.Thecom-

monusageofthetermvalueinvestorconnotessomeonewho

investsinstocksthathavesuchcharacteristicsaslowprice-

to-earnings(P/E)ormarket-to-book(M/B)ratios.Italso

referstothose

peoplewhobuystocksafterthemarketpriceshavefallensubstantially.

Presumably,suchinvestorshaveasufficientunderstandingoftheunderly-

ingbusinessesandexpectthepricestorecover.AsBuffett’swordsclearlystate,asmartinvestorshould

considerbothvalueandgrowthinvesting

simultaneously.Contrarytopopularbelief,Buffettisnotapurevalue

investor.Inthischapter,IillustratethewayBuffettcombinesvalueandgrowthinvestingstrategiestoearnhighreturns.

Date:Jan29,2010

Time:1:14pm

BerkshireHathawayIsaGrowthStock

Foreachofthepastfourdecades,BerkshirehasoutperformedtheS&P

500index.Table6.1presentstheannualizedratesofgrowthinBerk-

shire’sbookvaluepershare,Berkshire’sstockreturns,andcorrespondingreturnsontheS&P500index.Fortheentire40-yearperiodendingin

2008,Berkshire’sannualizedgrowthinper-sharebookvalueis20.7per-

centanditsannualizedstockreturnis21.8percent.Ifyouhadinvested

$10,000inBerkshirecommonstockatthebeginningof1969,your

investmentwouldhavegrownto$26.7million.On

theotherhand,

theannualizedreturnontheS&P500indexhasbeenonly8.9per-

cent,whichwouldhavegrownyourinvestmentfrom$10,000toonly

$302,000.Clearly,Berkshirehasbeenalong-termgrowthstock.

Berkshire’srateofgrowthseemstohaveslowedinrecentyears,maybe

becauseofitslargesizeandmaybebecauseofeventsincludingtheter-

roristattackontheUnitedStatesin2001andthemarketcrashin2008.

Since1965,Berkshirehassufferedadeclineinbook

valuepershareonly

in2001and2008.Still,eveninthemostrecentdecade,Berkshirehas

generated4.7percentabovethecorrespondingreturnsontheS&P500

index.

Berkshire’sresultsinTable6.1includethosefromits

majority-owned

orwhollyownedsubsidiariesanditsminorityholdingsthroughcommon

Table6.1

Berkshire’sPerformanceversustheS&P500

AnnualChange

Inper-share

InS&P500

Berkshire’sstock

10-yearperiods

bookvalueof

InBerkshire

(dividends

performance

andthe40-year

Berkshire

stockprice

included)

relativetoS&P500

period

(2)–(3)

1969–1978

1979–1988

1989–1998

1999–2008

−1.4

1969–2008

Date:Jan29,2010

Time:1:14pm

stocks.DetaileddataonpurchasingandsellingdatesandpricesonBerk-

shire’sminorityinvestmentsincommonstocksarehardertocollect.

However,GeraldMartin

fromAmericanUniversity,WashingtonDC,

andJohnPuthenpurackalfromUniversityofNevada,LasVegas,col-

lectedthedetaileddataonBerkshire’sinvestmentsincommonstocks

andanalyzedthemcarefully.2For1976–2008,theBerkshirecommon

stockportfoliogeneratedanaveragereturnof18.2percent,handilybeat-

ingthe10.6percentthattheinvestmentswouldhavegeneratedifthe

investmentshadbeenmadeintheS&P500index.

ItseemsalmostimpossibletoduplicateBuffett’strackrecord.How-

ever,thegoodnewsisthatovertheyears,hehasprovidedanextensive

bodyofwrittenandspokenmaterialonhisideasandprinciples.Evenif

wecannotduplicateBuffett’sresults,weshouldatleastbeabletolearnfromhisownmethodstoimproveourresults.IbeginwithabriefdiscussionofwhyBuffett

mayhaveinitiallyinvestedinGEICOin1976,

andlateralludetosomeotheracquisitionsanddrawsomeinferenceson

salientfeaturesofhisinvestingstyle.

ValuePlusGrowth

GEICO’sstockpricesoaredfrom$5inthelate1950sto

morethan$60

in1972.Then,theCinderellastoryended.Onthebrinkofbankruptcy,

thestocktradednear$2persharein1976.By1977,Berkshirehad

purchased1.29millionsharesfor$4.1million,averaging$2.55pershare.

Inaddition,Berkshireinvested$19millioninaGEICOconvertible

preferredstockissuanceof$75million.By1980,Berkshire’sinvestment

inGEICOwas$47million,whichamountedtoabouta33percent

equityinterestinGEICO.AsGEICOrepurchaseditsown

sharesover

thenext15years,Berkshire’sownershipofGEICOincreasedto50

percent.

Invalueinvesting,thepurposeofusingtheP/Eratiooranother

metricisnottobenefitfromsomespecialqualityofthe

metricperse.

Theunderlyingpurposeofusingsuchmetricsistowarntheinvestor

toinvestonlywhenthedownsideriskislow.Atthetimeoftheinitial

GEICOpurchase,thecompanywasincurringlosses,andhence,the

P/Eratiowasmeaningless.Becausethecompanywasabouttodeclare

Date:Jan29,2010

Time:1:14pm

bankruptcy,itsbookvaluealsodidnotmeanmuch.However,after

raisingadditionalequityfromBerkshireandothers,thecompanywas

savedfromfilingforbankruptcy.Consequently,Buffett’sinvestmentdid

nothaveahighprobabilityoflosingmoney.ThisattentiontodownsideriskisthemainingredientthatBuffettborrowsfromthevalueinvestingstrategy.

IfBuffettwerejustaplainvanillavalueinvestor,hewouldprobably

havesoldtheGEICOsharesafterthepricehadgoneupbymorethan

100percentinlessthanayearofhisinitialpurchaseorwithinafewyearsthereafter.HeunderstoodGEICOwell,ashehadfollowedthecompany

since1951.Overall,heinvestedinGEICOforitspotentiallong-term

growth,justasagrowthinvestorwould.Berkshire’s$47millioninvest-

mentinGEICOgrewbyabout50times,to$2.3billion,by1995when

hepurchasedtheremainderofthefirm.GEICOisagoodexampleof

howBuffett’ssuccessliesinidentifyingcompaniesthatarenotjustvalueinvestmentsbutalsohavegoodgrowthpotential.Buffett-styleinvesting

orBuffettinvestingisnotjustpurevalueinvesting;itisvalueplusgrowthinvesting.

Thevalueinvestingapproachissometimesknownasthequantitative

approachbecauseofitsfocusonmathematicalvariablessuchastheP/E

ratio,whilethegrowthinvestingapproachisoften

referredtoasthequalitativeapproachbecauseofitsfocusonharder-to-calculatevariablesbasedonfutureestimates.Obviously,Iamnotclaimingtohavediscoveredthe

approachofcombiningvalueandgrowthasasuperiorapproachtovalue

investing;Buffettgetsfullcreditfordevelopingit.

Buffetthasdescribedhisinvestingapproachinbitsandpiecesinmanydifferentplaces.The

followingstatementstakenfromhis1967lettertohispartnersprobably

givethebestcluestohisphilosophicaldevelopmentinthisregard.He

writes:

AlthoughIconsidermyselftobeprimarilyinthequantitativeschool,

thereallysensationalideasIhavehadovertheyearshavebeenheavily

weightedtowardthequalitativesidewhereIhavehada“high-

probabilityinsight.”Thisiswhatcausesthecashregister

tosing.

However,itisaninfrequentoccurrence,asinsightsusuallyare,and,

ofcourse,noinsightisrequiredonthequantitativeside—thefigures

shouldhityouovertheheadwithabaseballbat.So,thereallybig

Date:Jan29,2010

Time:1:14pm

moneytendstobemadebyinvestorswhoarerightonqualitative

decisions,but,atleastinmyopinion,themoresuremoneytendsto

bemadeontheobviousquantitativedecisions.3

Clearly,Buffettbelievesthataconsiderableemphasisongrowth

investingisnecessaryifonewantstoearnlargereturns.

ImplementingValuePlusGrowth

ToimplementBuffett-styleinvestingforcommonstocks,youmay

employatwo-stepprocess.First,decidewhetherthedownsiderisk,

ortheriskoflosingyourinvestment,islow.Often,lowP/EorM/B

metricssuggestalowdownsiderisk.Second,afterhavingjudgedthat

thedownsideriskislow,youshouldanalyzethestock’sgrowthpotential

andcomputeitsintrinsicvalueandmarginofsafety.Youshouldbuya

stockifthemarginofsafetyishigh,evenifitsP/Eis

abovethemarketP/Eorabovethecompany’shistoricalaverageP/E.Notallyourinvestmentswillturnouttobewonderfulgrowthstocks.However,sinceyou

protectedyourselfbytakingalowdownsiderisk,youwillnotloseoften

and,whenyoudounavoidablylose,youwillnotlosemuch.AsIexplain

next,yourgainscanstillbeveryhighifonlyafewofyourinvestments

turnouttobetrulysuccessfulgrowthstocks.

Thesubstantialbenefitofinvestingingrowthstockscanbeillustrated

byahypotheticalexample.Itshowsthatevenifonlyoneoutofevery

fiveofyourstockinvestmentsdoeswell,youroverallreturncanbe

high.Assumethattheaveragemarketreturnis10percent.Youinvest

$1,000ineachoffivestocksforatotalinvestmentof$5,000witha

three-yearhorizon.Ifyouearn10percentperyearas

expected,your

$5,000investmentwouldbecome$6,655attheendofthreeyears.But

ifjustoneofyourfivestocksturnsouttobeagrowthstockwitha

200percentreturnoverthethree-yearperiod,yourportfoliowouldbe

worth$8,324—asubstantiallyhighersumthanthe$6,655.Theannual

compoundedratewithonesuccessfulgrowthstockturnsouttobe18.5

percentperyear.

Thevalueplusgrowthconceptcanbefurtherillustratedusingsome

ofBerkshire’sinvestments.From1987to1991,Berkshireinvesteda

totalofabout$2billioninfiveconvertiblepreferredstocks:Champion

Date:Jan29,2010

Time:1:14pm

International,FirstEmpireState,Gillette,SalomonInc.,andU.S.Air.

Alltheseinvestmentscouldbecharacterizedasvalueinvestmentsbecause

thedownsideriskwaslow.

Largecompanypreferredstocks,onaverage,

aresafeinvestmentsbecausetheyarenotexpectedtodefaultontheirdividendpaymentsortheprincipalamounts.Outofthesefive,onlyGillette

turnedouttobeagoodgrowthstock.In1990,Berkshireinvested$600

millioninGillette,whichwastakenoverin2005byProcterandGam-

ble,withBerkshirereceivingabout$5billioninProcterandGamble

stockinexchange.Overthe15-yearperiod,Berkshireearnedabout16

percentperyear,whichwastwicetherateontheS&P

500indexforthesameperiod.Theotherfourinvestmentsessentiallygeneratednormal

returns.In2008,Berkshireinvestedinthreepreferredstocksorconvert-

ibleinstrumentsthataresimilartopreferredstock.Theyareissuedby

GoldmanSachs($5billion),

GeneralElectric($3billion),andWrigley

($6.5billion).Evenifoneofthemturnsouttobeagrowthstock,returnstoBerkshirewillbehigh.Ifnot,Berkshirewillearndecentintereston

theseinvestments.

Itisimportanttorealizethatlowdownsideriskisveryimportant.

Inthepreviousexampleofpickingfivestocks,ifyouweretopickthem

fromafast-growinghigh-techindustry,youwouldhaveprobablylost

allyourinvestmentinoneortwostocks.Assumingthatyoumake200

percentononestockaspointedoutearlier,earnthe

marketreturnon

theremainingtwo,andloseallyourinvestmentintwostocks,your

finalsumwillbe$5,662,givingyouanannualrateofonly4.2percent

onyourinitial$5,000investment.Thisissubstantiallylessthanthe10

percentthatyouwouldhaveearnedhadyousimplyinvestedinthe

market.

AtleasttwoofBuffett’swell-knownpracticescanbedirectlylinked

tothetwo-stepprocessI’veoutlined.First,considerhispracticeofinvestingonlyinhiscircleofcompetence.In

thetwo-stepprocess,youneedtocomputeastock’sintrinsicvalue,whichrequiresreliableearningsforecastsforseveralyearsinthefuture.Youcanforecastwellonlywhenyouknowthecompanywellorwhenitisinyourcircleofcompetence.Second,Buffettrarelyinvestsinhigh-techorfast-growingindustries.One

possiblereasonmaybethat

theyarenotinhiscircleofcompetence.But

evenifBuffettknewalotaboutsomefast-growingcompanies,hemight

avoidthembecauseitishardtofindstockswithahighmarginofsafety

Date:Jan29,2010

Time:1:14pm

intheseindustries.Often,investorshavehighexpectationsfromsuch

stocksandbidtheirpricesveryhigh.Onaverage,theyareovervalued;

thatis,thereisnomarginofsafety.InBuffett-styleinvestingor,inotherwords,ifyouarelookingforstocksthatBuffettwouldwanttobuy,you

arebetterofflookingintraditionalindustries.

WhereDoesGrowthComeFrom?

AsIsaidbefore,Buffettdoes

notinvestinhigh-techorfast-growing

industries.Then,howhasheaccomplishedahighrateofgrowth(over

20percent)foranextendedperiod?Thekeyseemstobehisempha-

sisonqualityofmanagement.Hisphilosophyisthesamewhetherhe

acquirescompaniesorinvestsincommonstocks.Thereareseveralchar-

acteristicsinhismanagementphilosophythat,combined,providethis

outcome.

WhenacompanyisacquiredbyBerkshire,managersdonotface

financialanalystsorworryaboutthestockprice.Berkshireanditssub-

sidiariesdonotforecastearningsanddonotconductconferencecalls

withanalysts.Themanagersdonothavetomeetorbeatthenextquar-

ter’sornextyear’searnings.Thisfreesuptheirtimeand

allowsthem

toconcentrateonthecompany’slong-runoperatingperformance.The

compensationplansarealsodesignedtoaccomplishwhatacademicscall

“maximizationofshareholdervalue.”Valueisfurthercreatedwithreduc-

tionsincostsonceafirmcomesundertheBerkshireumbrella.Berkshire

doesnotleveruptheacquiredcompany.Thishastwoadvantages.First,

inkeepingwithBuffett’sphilosophy,thedownsideriskismaintainedat

alowlevel,andsecond,employeesarehappieras

theyaremoresecure

oftheiremployment.Similarly,otherinputcostssuchasrawmaterials

andrentarealsolowerbecausesuppliersfeelmoreassuredofprompt

payment.Themainlessonfromthisisthatafteracquisitions,Buffett

helpsenhancemanagementqualityeventhoughheemphasizesthatgood

qualitymanagementshouldalreadybeinplacebeforehepurchasesa

company.

OneofBuffett’sacquisitioncriteriaisdeceptivelysimplebutvery

insightful.Heacquiresacompanyonlyifthecurrentmanagementcomes

withtheacquisition.Thisisratheruniquebecausemostacquirersreplacetheincumbentmanagementwithanewteamoftheirown.Whydoes

Date:Jan29,2010

Time:1:14pm

Buffettgoagainstthenorminthebusinessworld?Tostartwith,itis

obviousthatiftheacquiredbusinesswassuccessfulundertheexisting

managers,theyshouldnotbereplaced.However,mostotheracquirers

replacethemanyway.Maybe,thereishubrislurkinginthebackground.

Myguessisthatmostacquirersprefertomanagebiggercompanies.This

helpstheircompensationpackage,theirego,andtheir

influenceinthe

businessworld.

Buffett’sapproachhasadditionaladvantages.Iftheacquiredcompany

wasaprivatecompany,asisfrequentlythecase,theCEOwasprobably

alsotheowner.UnderBerkshire,heisstilltheCEO

ofhisunitbutisnowamanagerunderBuffett.Althoughheisnowamanagerratherthanan

owner,heislikelytobehaveasanownerbecausehewasanownerbefore

hesoldhiscompanytoBerkshire.Ineconomicparlance,thisreduces

theprincipal-agent,or

conflictofinterests,problem.Ifthemanager

behavesasanowner,thereisnoconflict.Inmostcases,thesellersare

independentlywealthyandmoreinterestedinsuccessfulgrowthoftheir

companiesthantheirowncompensation.Additionally,sincetheseller

getstokeepthecompanyunderhiscontrol,hemaybewillingtotake

alowerprice.Finally,ifsomecompanymanagementhadmanipulated

earningsinthepasttogetagoodpricefromsellingthecompany,the

sellerprobablywouldnotsellittoBuffett.Thisisbecause

Buffettwouldaskhimtostayonandmanagethecompany.Mosthiddenproblems(for

example,earningsmanagementoroff-balance-sheetdebt)arelikelyto

surfacewithinafewyears.Noonewouldwanttomanageacompany

knowingthatithassuchatickingtimebomb.This

reducesthelikelihood

ofBuffettendingupwithdishonestmanagersandsolvesthe“letthe

buyerbeware”problem.

BuffettalsopromisesthosewhoselltheirfirmstoBerkshirethathe

willholdthepurchasedcompaniesforeverevenif

profitabilitydeclines.

IdonotknowofanymajoracquisitionthatBerkshirelatersold.Why

isthisimportant?Itbuildstrustandsecurityintheseller’smindaboutthefutureofthecompany,especiallyifthesellerwantstobesurehis

businesswillprosper.AsBuffettwrites,“Wehavea

decidedadvantage,

therefore,whenweencountersellerswhotrulycareaboutthefutureof

theirbusinesses.”4Overall,Buffett’sacquisitionprinciplesaredesignedtoproducehighearningsforalongtime.Inessence,growthisaccomplished

throughgoodmanagement.

Date:Jan29,2010

Time:1:14pm

ExamplesfromBerkshireInvestments

Overthepast44years,Berkshirehasacquiredalargenumberofcom-

paniesandhasinvestedincommonstocksofcompaniesasaminority

shareholder.Buffetthasmentionedthattheprinciplesappliedforthese

twotypesofinvestmentsarethesame.Whilethereisa

commontheme

acrosshisinvestments,notwoinvestmentsareidentical.Toenrichour

understandingofBuffettinvesting,Ibreakdownafewofhisinvestment

decisions.

Railroad:BurlingtonNorthernSantaFe

During2006to2008,Berkshireacquired70.1millionshares,or20.1

percent,ofBurlingtonNorthernSantaFe(BNSF),whichoperatesoneof

thelargestNorthAmericanrailnetworks,withabout32,000routemiles

across28statesandtwoCanadianprovinces.

Berkshirepaidabout$78

pershareforatotalinvestmentof$5.5billion,makingitthethird-largestBerkshirecommonstockholdingbehindCoca-ColaandWellsFargo.

BNSFis,nexttoUnionPacific,oneofthetoptwoU.S.railroads,each

bringinginabout$18billion

inrevenues.Itwasformedfromamerger

betweenBurlingtonNorthernandSantaFePacificin1995.BNSF’s

financialstatementsprovideinsightsintoitsvaluationandthereasonsforthislargeBuffettinvestment.Thedatafrom1996to2008(selectedyears

forbrevity)arepresentedinTable6.2.

First,followingthevalueinvestingprinciples,thedownsideriskis

low.Thelong-termdebtisonly25percentoftotalassetswhichisreasonableforacompanywithlargeholdingsinproperty,plant,andequipment.

Thecompanygeneratessteadycashflowsastheserviceitprovidescannot

beeasilyreplacedbyanothervendor.Fromreadingtheannualreportsof

BNSFandotherrailroads,Igatherthatthecompanyhasalargemarket

shareinseveralregions.Furthermore,returnonequity

(ROE)hasbeen

stableataround13.5percent.Overall,theeconomicsofthebusinessseemgood.Also,therailroadbusinessisaneasyoneforinvestorstounderstand,aprinciplethatBuffettemphasizes.Buffettdidnotpayahighpriceinrelationtoearnings.Hispurchaseprice-to-earnings(P/E)ratiobased

ontheaverageearningspersharein2005and2006is15.3.Thisisonly

slightlyhigherthatBNSF’s13-yearaverageP/Eof14.9andiscloseto

Date:Jan29,2010

Time:1:14pm

umbern

selected

evitybr

Highlights

FinancialeF

per-shar

$18.02

$36.40

$11.13

$75.71

except

assets

equity)

billions,

assets

(millions)

vidend/Pr

eholder’

equity

year-end

Burlington

expense

amounts

income

income/T

equity

debt/T

expenditur

Dollar

income

assets

eholder

eciation

vidends

income/Shar

vidend

ice-to-ear

Operating

Long-ter

Number

Capital

Operating

Long-ter

Date:Jan29,2010

Time:1:14pm

thelong-runS&P500P/Eratioof16.Whilenotcheap

intermsofthe

P/Ethatapurevalueinvestormayprefer,BNSF’svaluationfitsBuffett’sapproachofpayingareasonablepricewhentheeconomicsandgrowth

prospectsofthebusinessaregood.Inhiswords,“It’sfarbettertobuy

awonderfulcompanyata

fairpricethanafaircompanyatawonderful

price.”5

Second,thegrowthprospectsareaboveaverage.Aseriesofdata

spanningalongperiodallowsustoestimatefuturegrowthwitharea-

sonabledegreeofconfidence.

Thegrowthrateinearningsoverthepast

fiveyearswas23percentperyear,butthegrowthoverthepast12years

wasonly10percentayear.Itappearstomethattherecentgrowth

rateisonthehighsideastheeconomywasdoingwellwithdemand

forcoalandagriculturetransportationincreasingatafaster-than-normalrate,probablybecauseofhighoilprices.BNSF’sincreasedgrowthrate

hasdrivenitsROEtoanunusuallyhighrateof19.0percent.Willthe

growthcontinue,andatwhatrate?Thatisprobablythemostdifficult

questionaBuffett-styleinvestorfaces.

BNSFhastheusualsourcesofgrowth,suchasrevenues,acquisitions,

andproductivity.Ithasalsoincreasedearningspersharethroughshare

repurchases,whichthefirmislikelytocontinuebecauseofitssignificantfreecash

flows.Sharerepurchaseshaveslowlyreducedthenumberof

sharesoutstandingfrom456millionin1996to348millionin2008

(areductionof24percentover12years).Thus,a2percentgrowthrate

canbeexpectedbasedonsharerepurchasesalone.For

futureprojection,

Istartwiththe12-yearhistoricalgrowthrateof10percentandreduce

itby1percentto9percenttobeconservative.

Witha9percentgrowthrate,BNSF’sexpectedearningsin10years

willbe$14.39pershare.

ApplyingaP/Eof15,theexpectedpriceat

theendof2018is$216pershare.Thepresentvalueof$216usinga

discountrateof7percentis$110pershare.Inaddition,aninvestorwillgetdividends,whichIassumewillalsogrowattherateof9percentper

yearfromthecurrentlevelof$1.44pershare.Thepresentvalueofthe

dividendsisabout$14,givingusanintrinsicvalueforBNSFofabout

$124($110+$14)pershare.Inearly2009,theBNSFstockpricewas

$68.Itwasagoodinvestmentatthisprice.

OnNovember3,2009,Berkshireannouncedaplantoacquire,at

$100pershare,theremaining77.4percentofBNSF’soutstandingshares

Date:Jan29,2010

Time:1:14pm

notcurrentlyownedbyBerkshire.Baseduponthenumberofshares

remainingforBerkshiretoacquire,thevalueoftheaggregateconsid-

erationtocompletethe

acquisitionisapproximately$26.4billion.This

willbethelargestBerkshireacquisitionever.Overall,thedownsideriskislow,thepriceisnothigh,andgrowthpotentialsaregood.Itisa

quintessentialBuffettinvestment.

Training:FlightSafetyInternational

In1996,BerkshireHathawayacquiredFlightSafetyInternational(FSI),

alargecompanyprovidingpilot,flightattendant,andmechanictraining

servicesintheUnitedStates,Canada,andEurope.Intermsofthevalue

investingprincipleoflowdownsiderisk,themost

relevantfactwasthat

thethenCEO,A.L.Ueltschi,owned31.8percentofthecompanyand

electedtoreceiveBerkshiresharesinexchangeforhisFlightSafetystock.

Thus,hewasnotsellingthecompanybecausehedidnotbelieveinits

future.HeremainedtheCEOuntil2003andisstillthechairmanofthe

board.BruceWhitman,anemployeesince1961,becametheCEOin

2003.A.L.Ueltschifoundedthecompanyin1951anditssharesstarted

tradingpubliclyin1968.PraisingUeltschi,Buffett

wrote,“Almaybe

79,buthelooksandactsabout55.Hewillrunoperationsjustashehas

inthepast.Weneverfoolwithsuccess.”6

Inthefive-yearperiodpriortotheacquisitionbyBerkshirein1995,

FSI’srevenuesgrewfrom

$267millionto$326million,anannualized

growthrateof5.1percent,similartowhatisexpectedinthetraditionalindustries.FSI’snetincomegrewalittlefasterattherateof6.5percent,butnoonewouldhaveclassifiedFSIasagrowthstock.Thepriceof

$1.5billionpaidbyBerkshirewasabout2.5

timesthebookvalueand

18timesearningsin1995.Thus,Buffettdidnotpayahighpricefor

thecompany,butitwasnotcheapeither.AsIdiscussedearlier,good

companiesarerarelyavailablecheap,andinthatsenseBuffettisnota

purevalueinvestor.

Howaboutgrowth?FlightSafetygrewquicklyafteritwasacquired.

BuffettwroteinBerkshire’s1998annualreport,“FlightSafety’soperatingprofitsincreasedsignificantlyover1997asaresultofcontinuedgrowthinallareasofitstrainingbusiness.”7Thecapital

expendituresatFlightSafetyduring1997,1998,and1999wereabout20percentoftheidentifiable

Date:Jan29,2010

Time:1:14pm

assetsatyear-end.Thiswasatleasttwicetherateofcapitalexpendituresbeforeitwasacquired.BuffettmadeitpossibleforFSItogrowbykeepingsuccessfulmanagementinplace.Company-specificdataarenotavailable

since1996,butthecompanyremainsoneofthelargest

companiesinits

industry.

Aviation:NetJets

NetJets,formerlyknownasExecutiveJetAviation(EJA),wasacquired

byBerkshirein1998for$725million.NetJetssellsfractionalsharesof

jetsandoperatesthefleetforitsmanyowners.NetJetsdoesnotownmostoftheseairplanes;theyareownedbycustomers.WarrenBuffettwasa

satisfiedcustomerforthreeyearsbeforehemadethisacquisition.NetJets,aprivatecompany,grewfastunderitsCEOandmajorityshareholder,

RichardSantulli,whopioneeredthefractionaljetownershipconceptin

1986.HestayedwithhiscompanyjustasmostotherCEOsofBerkshire

acquisitionsstaywiththeircompanies.Idiscussedearlierthatmanagers

arethepurveyorsofgrowth.However,whenalong-term,

successful

CEOstayswiththecompany,itisalsoanindicationthatthedownside

riskintheacquisitionislow.WhenRichardSantulliresignedin2009,

DavidSokol,CEOofBerkshire’ssubsidiaryMidAmerican,tookoveras

thenewNetJetsCEO.

Whatistheusualsourceofahighgrowthrateintheoldeconomy

orinawell-establishedindustry?Insomecases(recallWal-Martand

GEICO),growthcomesfromtakingmarketshareawayfromotherfirms.

Inthiscase,NetJetsgrewbyluringbusinessandfirst-classtravelersintraditionalairlinesandcorporatejetowners.

SinceBerkshireboughtNetJets,growthinrevenueshasbeenwell

abovethenormalgrowthofabout5percentto7percentinso-called

traditionalindustries,whichincludeaviation.AsBuffettwroteinMarch

2000,“Currently,ourcustomersownplanesworthover$2billion,and

inadditionwehave$4.2billionofplanesonorder.Indeed,thelim-

itingfactorinourbusinessrightnowistheavailability

ofplanes.”8In2007,Buffettexplainedhowgrowthmayhavebeenaccomplished:“The

NetJetsbrand—withitspromiseofsafety,serviceandsecurity—grows

strongereveryyear.Behindthisisthepassionofoneman,RichardSan-

tulli.Ifyouweretopick

someonetojoinyouinafoxhole,youcouldn’t

Date:Jan29,2010

Time:1:14pm

dobetterthanRich.Nomatterwhattheobstacles,hejustdoesn’tstop.”9

Onceagain,itappearsthatmanagementqualityisthewaytogrowth.

Itshouldnotbeassumedthatgrowthisasurethingevenifanaccom-

plishedCEOisatthehelm.InthecaseofNetJet’s

Europeanexpansion,

thecompanyincurredacumulativelossof$212millionoveritsfirst10

yearsinoperationstartingin1996.However,Buffettreportedin2007

thattheEuropeansegmentwasnowdoingwell.Buffettgivescreditto

RichardSantulli,whoappointedanewpersontoleadtheEuropean

segment.Thissequenceofeventssuggeststhatexperiencedmanagers

arehelpfulinmaintainingalowdownsideriskintimesoftrouble.

BerkshirecombinesfinancialnumbersonNetJetsandFSI

underone

segmentcalledFlightServices,andeventhen,dataareavailableonlyforcertainyears.Forthetwocompaniesdiscussedhere,Buffettproudly

states,“[A]commoncharacteristicofthecompaniesisthattheyare

stillmanagedbytheir

foundingentrepreneurs....Thesemenarebothremarkablemanagerswhohavenofinancialneedtoworkbutthriveon

helpingtheircompaniesgrowandexcel.”10

For1999,thefirstyearbothsubsidiariesoperatedforafullyearunder

Berkshire,revenueswere

$1.86billionwithidentifiableassetsof$1.79

billion.For2005,thelatestyearforwhichdataareavailable,revenues

were$3.66billion,andidentifiableassetswere$3.17billion.Insixyears,revenuesgrewatarateof12percentperyearandassetsatarateof

10percentperyear.Becauseofcontinuingexpansion,profitabilityhas

beenerratic.11Operatingprofitsin2005wereonly3.8percentofyear-

endidentifiableassets.Thediscussioninthe2006annualreportsuggeststhattheresultshaveimprovedsubstantially.Berkshiredidnotpresentthedetails,butI

estimatethatoperatingprofitswereabout11percentof

theidentifiableassetsemployed.From1999to2007(thelastyearfor

whichearningsdataareavailable),pretaxearningsintheFlightServicessegmenthavegoneupfrom$225millionto$547million,anannualized

growthrateofabout12percent.

NetJetsalsoshowshowagrowthcompany’sprofitabilityisgenerally

tiedstronglytotheeconomy.Theglobalrecessionof2008–2009hada

significantimpactonNetJets.Thecompanyproducedpretaxlossesof

$531millionforthefirstninemonthsin2009.Overall,NetJetsisstill

anevolvingstory,butBuffett’semphasisonpatienceandhigh-quality

managementcomesthrough.

Date:Jan29,2010

Time:1:14pm

High-Tech:BYD

OnSeptember29,2008,Berkshireannouncedplanstoinvest$230mil-

lionfora10percentstakein

BYD(initialsfortheChinesename),a

fast-growingChinesecompanylistedinHongKong.Theinitialsare

nowusedfor“BuildYourDreams.”With2008revenuesof$3.9bil-

lionandtotalassetsof$4.8billion,BYDisoneoftheworld’slargest

manufacturersofrechargeablebatteriesandhandsetcomponents.Itis

alsoasuccessfulcarmanufacturer.Since2002,itsrevenueshavegrown

abouteighttimesfrom$500milliontothecurrentlevelof$3.9billion,

mostofthegrowthcominginternally.Itisa

quintessentialrags-to-richesHoratioAlgerstoryforBYDCEOWangChuan-fu.

Basedon2008reportedearningspershare,BYD’sP/Eratioatthe

timeofBerkshire’spurchasewasabout14,inlinewithotherBerkshire

acquisitions.Furthermore,asTable6.3shows,BYD’s

earningspershare

havebeensteady,ifnotgrowingconsistentlywithrevenues.Thedebt-

to-total-assetsratioof0.28appearstobefairlyconservative.Overall,thedownsideriskfromthisinvestmentisnothigh.SoonaftertheBerkshire

investment,inOctober2008,

theBYDstockpricedoubledandthen

movedsteadilyupwardanddoubledagainoverthenextseveralmonths.If

Buffettwereapurevalueinvestor,hewouldhavesoldhisstakewhenthe

pricequadrupled.However,duringtheBerkshireannualshareholders

meetingonMay2,2009,CharlieMungermadeitclearthattheBYD

investmentisforthelongterm.

YoumaywonderwhyBerkshiremadeacommitmenttoalong-term

investmentinafast-growinghigh-techcompany.Theanswer:BYDis

agloballeaderintwoofitsthreebusinesses(rechargeablebatteriesandhandsetcomponents),Berkshiredidnotpayahighpriceforit,and

Berkshire’ssubsidiaryMidAmericanhasincentivestohelpBYDsucceed

inproducinginexpensiverechargeablebatteries.MidAmerican’sCEO

DavidSokolisnowanonexecutivedirectorontheBYDboard.Asone

ofthelargestwindpowergeneratorsintheUnitedStates,MidAmeri-

cancanbecomeamajoruserofrechargeablebatteriestostoreenergy

fromwindpowergeneration.Atalowprice,theworldwide

demandfor

rechargeablebatteriesisimmense.

Combiningitsknowledgeofrechargeablebatteriesandautomobiles,

BYDintroducedahybridelectriccarinDecember2008.Ifsuccessful,

Date:Jan29,2010

Time:1:14pm

Table6.3

BYD’sSelectedFinancialData

Revenues

Totalassets

Debt(interestbearing)

Shareholders’equity

Netincome

Earningspershare

Debt/Totalassets

Returnonequity(percent)

Numbersareinbillionsof

ChineseYuan(RMB),exceptearningspershareandratios.

itcanbeaworldleaderinelectriccarproduction.Thatmaybethereal

growthstorythathasgeneratedsomuchexcitementforthefirm.12At

theBerkshireannualmeetinginMay2009,largecrowdsgatheredtosee

theprototypes,whichareexpectedtobeintroducedintheUnitedStates

inthenearfuture.

Fromaninvestingpointofview,evenifthecarprojectisnotabighit,thecompanyisalreadygeneratingsatisfactoryprofitsfortheshareholders.

Currentlevelsofprofitsmust

havegivencomforttoBuffetttoinvestin

thisventureevenifhedidnotcompletelyunderstandthetechnology.

Afterall,hedidnothavetofullyunderstandthetechnology;DavidSokolisBuffett’seyesandearsinthiscase.ItalsomakessenseforMidAmericantohelpBYDinlaunchinganelectriccarin

theUnitedStatesasitwill

increasedemandforelectricity,replacingacorrespondingdemandfor

importedoil.Finally,again,forsuccessfulinvesting,Buffetthasalwaysemphasizedtheimportanceofmanagementquality.CharlieMungerand

BuffetthavepraisedtheBYD

CEOhighlyonseveraloccasionsforhis

accomplishments.So,itappearsthatBYDisnotaspeculativeinvestment

eventhoughitisinthehigh-techfield.

Overall,Buffett’sinvestmentsaregenerallynotdrivenbythecon-

ceptofvalueinvestingalone.Asavalueinvestor,hekeepsthedownside

Date:Jan29,2010

Time:1:14pm

risklowbutiswillingtopayareasonablepriceforexpectedgrowth.

TheBNSFinvestmentinatraditionalcompanyisaquintessentialBuf-

fettinvestment.TheBYDinvestment,eventhoughitisinahigh-tech

company,isagoodexampleofBuffett-styleinvestingin

thatitrepresentsthewayheblendsvalueandgrowthinvestingprinciplestogether,andin

thewaygrowthisaccomplishedthroughhigh-qualitymanagers.

Conclusions

Themainmessagefromvalueinvestingstrategiesistoinvestwithlow

downsiderisk.Ifastocksatisfiesthiscriterion,youshouldthenconsideritsgrowthinearningstoimplementavalue-plus-growthstrategythat

IcallBuffett-styleinvestingorsimplyBuffettinvesting.13Thefocusinvalueinvestingisonthepast,thefocusingrowthinvestingisonthe

future,andthefocusinBuffettinvestingisonboththepastandthe

future.Youshouldalsopayspecialattentiontomanagementquality,

becausehigh-qualitymanagementisthesourceofgrowthinBuffett-style

investing.Toimplementthisstrategy,youshouldcompute

thestock’s

intrinsicvalueandcompareitwiththestock’sprice.Asaruleofthumb,ifthepriceisabouthalftheintrinsicvalue,itisworthinvestinginthatstock.

ThereismoretoBuffettthansimplyvalueandgrowthinvesting.

Buffettengagesinarbitrage

investing,investinginsilverfutures,bettingonoil,forwardtradinginforeigncurrencies,managingalargenumberofwhollyownedsubsidiaries,andwritingderivativecontracts.He

frequentlynarratesinvestment-relevantstoriesfromotherfieldssuchas

psychology,sports,countrymusic,andlifeingeneral.

Givenhisbroad

knowledgeandhisdeepunderstandingofinvestment-relatedtopics,I

prefertocallhimarenaissanceinvestorratherthanattemptingtopin

himdownundermorelimitingmonikers.Therestofthisbookillustrates

Buffett’smethodofextractingrelevantinvestmentinformationfromso

manyseeminglyunrelatedfields.

Date:Jan29,2010

Time:1:14pm

E1PART03

Date:Dec10,2009

Time:4:17pm

PartThree

OTHERPEOPLE’S

Mostcompaniessellproductsorservicesfirstandcollectcash

later.Buffettdoesthereverse

throughBerkshire’sinsur-

ancecompanies.Insurancecompaniescollectpremiumsin

advance.Buffettthenusesthiscash,whichisreallyotherpeople’smoney,forinvesting.InChapters7and8,IfocusonBerkshire’sinsurancebusinesses,whicharethemainstayofhissuccess.InChapter9,I

discusstaxdeferment,whichisanothersourceofotherpeople’smoney.

E1PART03

Date:Dec10,2009

Time:4:17pm

Date:Jan20,2010

Time:11:15am

Chapter7

Insurance:Other

People’sMoney

Ourmainbusiness—thoughwehaveothersofgreatimpor-

tance—isinsurance.TounderstandBerkshire,therefore,itis

necessarythatyouunderstandhowtoevaluateaninsurancecom-

pany.Thekeydeterminantsare:(1)theamountoffloatthatthe

businessgenerates;(2)itscost;and(3)mostcriticalof

all,the

long-termoutlookforbothofthesefactors.1

—WarrenBuffett

Berkshire’smainbusinessisinsurance,andWarrenBuffettcan

hardlyhidehisenthusiasmwhenhetalksaboutGEICO,a

Berkshire-ownedinsurerthat

primarilyprovidesautoinsurance.

ThereisprobablynobetterplacetolearnfromBuffettaboutbusinessandinvestingthanfromhislongandsuccessfulinvolvementwithGEICO.

Buffett’sprofessorandmentorBenjaminGrahamatColumbiaUniver-

sitywaschairmanofGEICO.AcarefulexaminationofBuffett’swritings

tellsuswhyheboughtGEICOsharesinitiallyandwhyGEICOhasbeen

successful.BuffettnarratesthestoryofhisdesiretolearndeeplyaboutGEICO:

[O]naSaturdayinJanuary1951,Itookthetrainto

Washington

andheadedforGEICO’sdowntownheadquarters.Tomydismay,the

Date:Jan20,2010

Time:11:15am

otherpeople’smoney

buildingwasclosed,butIpoundedonthedooruntilacustodian

appeared.Iaskedthispuzzledfellowiftherewasanyoneintheoffice

Icouldtalkto,andhesaid

he’dseenonemanworkingonthesixth

floor....AndthusImetLorimerDavidson,AssistanttothePresident,whowaslatertobecometheCEO.2

BuffettreflectshisenthusiasminGEICOashecontinues,“WhenI

finishedatColumbiasomemonthslaterandreturnedto

Omahatosell

securities,InaturallyfocusedalmostexclusivelyonGEICO.”Andwhen

BuffettwasrunningBerkshire,hesaid,“Berkshirepurchasedalarge

interestinthecompanyduringthesecondhalfof1976,andalsomade

smallerpurchaseslater....Then,in1995,weagreedtopay$2.3billionforthehalfofthecompanywedidn’town.”Thus,GEICObecamea

whollyownedsubsidiaryofBerkshireHathaway,44yearsafterBuffett

firstsetfootinitsofficeinWashington.

InsuranceCompaniesasOtherPeople’sMoney

TheGEICOcommercialsbeckonpotentialcustomersbyclaiming,“A

fifteen-minutecallcouldsaveyou15percentormore.”Thisresembles

Wal-Mart’sslogan,visibleineveryWal-Martstore:“Wesellforless.”

GEICOhasthepotentialtobecometheWal-Martoftheinsurance

industry.GEICOhasbeentheengineofgrowthforBuffett’sinsurance

businessandhasgeneratedcapitalforBerkshiretoinvestinotheroppor-

tunities.Unlikemostotherbusinesses,aninsurance

companymakes

moneyintwodistinctways:(a)underwritingprofits,oroperatingprofits,and(b)float.

GEICO’sRevenuesandOperatingProfits

Whenyoubuyanautoinsurancepolicy,youpayapremium.Sub-

sequently,ifyousubmitaclaim,theinsurancecompanypaysyou.

Theunderwritingprofits,oroperatingprofits,arethedifference

betweenthepremiumsearnedandtheclaimsmadeinanygiven

period.

GEICO’soperatingprofitsandrevenuessince1996arepresented

inTable7.1.Ihavetwomainobservations.First,GEICO’srevenues

Date:Jan20,2010

Time:11:15am

Table7.1

GEICO’sRevenues,OperatingProfits,andOperatingProfits

Operating

profitsasa

profits

percentage

Revenues

beforetaxes

ofrevenues

$3,122

$2,917

−224

−4.0

10,101

11,055

11,806

12,479

$95,874

$7,144

andoperatingprofitshaveincreasedsubstantiallyovertime—butwhat

isevenmoreimpressiveisthatpercentageprofitability,orprofitsasa

percentageofrevenues,hasalsoincreased.Inmostcases,

especiallyinamatureindustrysuchasinsurance,profitsperdollarofrevenuesdecline

asthecompanygrowsbytakingmarketsharefromothers.Acompany

hastobeverywellmanagedtoincreaserevenuesandsimultaneously

increaseprofitability.

Mysecondobservationisthatoperatingprofitscanchangedramat-

icallyfromyeartoyear.Competitionintheinsurancemarketin1999

and2000drovedownpremiumrates,whichwasthemainreasonthat

GEICOwasclosetobreak-evenprofitsin1999and

incurredlossesin

2000.Sinceoperatingprofitsarevolatile,itisimportantformanagementtofocusonthelongrun—whichmanycompaniessimplycannotdo.As

aninvestor,youshouldexamineearningsforseveralyears,especially

whenanalyzinganinsurance

company.GEICO’soperatingprofitsasa

Date:Jan20,2010

Time:11:15am

shareofrevenuesaveraged6.4percentfrom1996to2008butarehigher,

at10.1percent,overthemostrecentfiveyears.

Insuranceisnotafast-growingindustry,butGEICOhasgrownfast.

ProgressiveInsurancecompeteswithGEICOandisofaboutthesame

size,with$13billionin2008revenues.Itsoperatingprofitabilityof10.1

percentoverthepastfouryearsisalsosimilartothatofGEICO.From

2004to2008,whilerevenuesatProgressivehaveremainedstagnant,

GEICO’srevenueshaveincreasedby40percent.

Buffettshareshisinsight

intoGEICO’sgrowth:“AtGEICO,ToneyNicely—nowinhis48thyear

atthecompanyafterjoiningitwhenhewas18—continuestogobbleup

marketsharewhilemaintainingdisciplinedunderwriting.WhenTony

becameCEOin1993,GEICOhad2.0percentoftheautoinsurance

market,alevelatwhichthecompanyhadlongbeenstuck.Nowwe

havea7.7percentshare.”3Inotherwords,Buffettsuggeststhatlong-

termprofitablegrowthinamatureindustryemanates

fromtheworkof

excellentmanagement.

Float:OtherPeople’sMoney

Unlikemostotherbusinesses,aninsurancecompanyreceivesmoney

fromitscustomers,intheformofpremiums,beforespendingmoneyon

theproduct.Thecompanypaysoutonlyafterclaimsarefiled.Mean-

while,thecompanykeepsthemoneyandcanearnareturnonthis

moneybyinvestingitinbondsandstocks.Thismoneyiscalledfloatininsuranceindustryparlance.

Overthepast10years,from

1998to2008,GEICO’srevenueshave

increasedfrom$4.0billionto$12.5billion,anincreaseof212percent,

whilefloathasincreasedfrom$3.1billionto$8.5billion,anincrease

of174percent.Therearetwodistinctadvantageousaspectsoffloatin

relationtootherliabilitiesordebt.First,eventhoughitisaliability,thecompanyisnotrequiredtopayanyinterestonit.Ifthecompanyfaces

financialhardshipforsomereason,thehardshipwillnotbeaccentuated

becauseofdebtholders.Inothercompanies,saymanufacturingcom-

panies,thedebtholdersmaybringadditionalhardshiptothecompany

indifficulttimesbyaskingfortheirmoneybackorbynotrenewing

theirloans.Second,growthininsurancecompaniesrequiresverylit-

tleadditionalcapitalexpenditure.Ifacompanyis

wellmanagedand

Date:Jan20,2010

Time:11:15am

grows,theleveloffloat

growsasthecompanygrows.Ontheother

hand,inmanufacturingcompanies,growthusuallyrequiressubstantial

additionalcapitalexpenditures,whichmaynecessitateissuanceofnew

debtorequity.So,thebenefitsfromgrowthinmanufacturingbusinesses

arenotashighasthosefromgrowthininsurancebusinesses.

HowhasGEICObeensosuccessful?Themainreasonisitsfocuson

thelongrunwhichmustbeattributedtoitshigh-qualitymanagement.

Forexample,considerearningsvolatility.While

mostcompaniesregard

earningsvolatilitytobeanuisance,ahigh-qualitymanagementteam

canactuallybenefitfromearningsvolatility.Whencompaniesencounterdecliningearnings,suchasinthesevererecessionof2008,mostpubliclytradedcompaniesreducemarketingeffortstotrimcosts.

However,

GEICOviewstimesofeconomicdownturnasopportunitiestoincrease

marketingeffortstocapturemarketsharefromothercompanies.This

mayreduceearningsintheshortterm,butitisagoodlong-runstrategy

thatGEICOcanengageinbutothercompaniesthatareworriedabout

short-termearningscannot.Buffett’sphilosophyoffocusingonthelong

runandignoringperiodicvolatilityisadvantageoustoGEICO.

InBerkshire’s1998annualreport,Buffettexplainsthis

approach.

“[C]ompaniesthatareconcernedaboutquarterlyorannualearnings

wouldshyfromsimilar[marketing]investments,nomatterhowintelli-

gentthesemightbeintermsofbuildinglong-termvalue.Ourcalculus

isdifferent:Wesimplymeasurewhetherwearecreatingmorethana

dollarofvalueperdollarspent—andifthatcalculationisfavorable,themoredollarswespendthehappierIam.”4In1995,GEICOspent$33

milliononmarketing,in1999,itspent$190million,andin2009,it

spentapproximately$800million.InthecaseofGEICO,Buffettsees

thelong-termbenefitsfromcapturingmarketshareanddoesnotworry

abouttheshort-termlossesfromincreasedmarketingexpenses.

GEICO’smanagementhasalsobeenabletomaintainor

evenincrease

itsoperatingprofitabilityasmentionedearlier.Operatinglosses,ifany,maybeviewedasthecostofgeneratingfloat.Onaverage,GEICOhas

beengeneratingoperatingprofits,notlosses.Thus,thereisnocostof

float.Inotherwords,GEICO’sfloatorother

people’smoneyisfree.

Foraninsurancecompany,boththeamountandthecostofthefloat

areimportant.ForGEICO’svaluation,discussednext,weusethesetwo

variables.

Date:Jan20,2010

Time:11:15am

GEICO’sValuationandReturnstoBerkshire

Since1996,GEICOhasbeenawhollyownedBerkshire

subsidiary.

Berkshirepaid$2.3billionforabouthalfthecompany,whichsuggests

GEICO’smarketvaluetobe$4.6billion.Therearetwosourcesofintrin-

sicvalueforGEICO.First,GEICO’soperatingprofits,accordingtomy

estimatesfromreadingthefinancialstatements,wereabout$100million

in1995.Usingamultipleof10tovaluethispretaxincomeamount

(whichisaboutaP/Eof15),Iestimatedthevalueofoperatingprof-

itstobe$1.0billion.Second,usingGEICO’sfinancial

statements,I

estimatedthecompany’sfloattobeabout$3.1billion.Sincethisfloat

isaninterest-freeloanfrompolicyholders,itsvaluetoGEICOcanbe

assumedtobe$3.1billion.ThisgivesusanestimateofGEICO’sintrin-

sicvaluetobe$4.1billion.Therewerealsosomeinvestmentsinexcess

offloat.Hence,myestimateofGEICO’sintrinsicvalueisconservative.

Overall,Berkshire’sacquisitionpricewasinlineoralittleoverGEICO’sintrinsicvalue.The1995purchaseofhalfofGEICOwasnotcheapasa

purevalueinvestorwouldlike.However,consistentwiththeargument

onBuffett-styleinvestinginthepreviouschapter,itwasacquiredforitsfuturegrowthpotential.

HowmuchwasGEICOworthin2009,basedonend-of-the-year

datain2007or2008?AsI

didbefore,Iuse10timestheunderwrit-

ingprofitsandaddfloattoit.Thisimpliesavalueof$18.8billion,

givenby(10×1.1)+7.8for2007data.Basedon2008data,whichareinfluencedbythedramaticeconomicslowdown,GEICO’svaluation

isstill$17.6(10×0.9+8.5)billion.Ipreferusing2007databecause2008isanunusualyear,althoughthedifferenceisnotsignificant.UnderBerkshire,GEICO’svaluehasincreasedfrom$4.6billionto$18.8billionin11years.Inaddition,Iestimatethatinthemeantime,GEICO

generatedabout$4billionoffreecashflows.Thesemay

havebeen

paidtoBerkshireindividendsorheldbyGEICOasinvestments.Thus,

GEICO’svalueof$4.6billionatacquisitionattheendof1995hasnow

goneupto$22.8billion,whichworksouttobeareturnofalittleover

13percentperyearsince1995.Incomparison,theannualizedreturn

ontheS&P500indexforthesameperiodwasonly4.8percent.Ido

notknowwhattoattributeGEICO’sgrowthtootherthanhigh-quality

management.

Date:Jan20,2010

Time:11:15am

PriorBerkshireInsuranceBusinessesandBlueChipStamps

Berkshire’sinsurancebusinessandBuffett’suseoffloatdidnotstartwithGEICO.Buffettusedotherpeople’smoneyfromseveralpriorbusinesses.

In1967,whenMalcolmG.Chacewasthechairman,andBuffettwas

aboardmember,Buffett’sinfluenceonBerkshirewasclearlyevidentas

Chacewrote,“Wearehighlypleasedwiththeresultsofourinsurance

subsidiariessincetheiracquisitionsinMarch1967....Ourinvestmentintheinsurancecompaniesreflectsafirstmajorstepinoureffortsto

achieveamorediversifiedbaseofearningpower.”5Itwasthebeginning

ofBuffett’slong-termplantotransformBerkshirefromamanufacturing

companyintoaninsurancegiant.ItisdifficulttoimaginethatBuffett

couldhaveachievedwhathehaswithoutalong-termplan.

Afterlearningabouttheinsurancebusinesswhilehewasastudentat

ColumbiaUniversity,heprobablythoughtitwasbettertoacquire100

percentofsmallinsurancecompaniesthantoacquiresharesinalarge

insurancecompanysuchasGEICO.Byacquiringentireinsurancecom-

panies,Buffettcouldinfluencethequalityof

insuranceunderwritingand

theuseofitsfloat.Afteritsinitialentryintotheinsurancebusinessin1967,Berkshireacquiredseveralsmallerinsurancecompaniesandstarted

newinsurancebusinesses.By1975,Berkshire’sinsurancesegmentcon-

stitutedabout64percentof

the$255millionofBerkshire’sidentifiable

totalassets.BythetimeanopportunityarosetoinvestinGEICOin

1976,Buffettwassavvyenoughtohandlealargecompanyandacquired

asignificantstake.

Insuranceisnottheonly

businessthatgeneratesfloat.Asfarbackas

1972,Berkshireowned17percentofBlueChipStamps,whichengaged

infurnishingatradingstampserviceinCalifornia,Nevada,andOregon.

In1973,BlueChipheld$93.4millionofwhatcanbetermedother

people’smoney—themoneyitcollectedthatwouldbegivenbackslowly

tocustomersastheyredeemedtheirstamps.Thesizeofthisfloatwas

almosttwicetheamountofitsshareholders’equityof$53.1million.In

1973,Berkshireincreaseditsholdingto19percentofthe

outstanding

sharesand,by1980,ownedabout60percent.In1984,BlueChipStamps

wasmergedintoBerkshire.

Withtime,tradingstampservicerevenuesdeclined.Manybusinesses

gotintotroubleastheirrevenuesdeclined,resulting

inasuddenloss

Date:Jan20,2010

Time:11:15am

ofshareholdervalue.

However,inwell-managedfloat-generatingbusi-

nesses,thetransitionisnotasseverebecausetheoutputisalmostneversoldataloss.Asthedemandforaproduct(tradingstampsinthiscase)

declines,thecompanymayreduceitssizeslowlywithoutmuchpainand

suffering.Theamountof

floatdoesnotdropasfastasrevenuesdecline.

Withrespecttofloatanddecliningbusiness,CharlieMunger,chairman

oftheBlueChipboard,wrotein1981,“Inourtradingstampbusiness,

our‘float’—islargeinrelationtocurrentissuances.(Tradingstamprev-

enuespeakedat$124millioninfiscal1970,andour1981revenuesof

$15.6millionthereforerepresentadeclineof87%frompeakvolume.)”6

BlueChip’sfloathasbeenagoodsourceforBerkshire’sgrowth.Using

thisfloat,Berkshireacquiredseveralcompaniesincluding

See’sCandies,

MutualSavings,BuffaloEveningNews,andPrecisionSteel.Whydid

Berkshireacquirethesebusinessesthatdonotseemtohaveanythingin

common?WegetagoodinsightintoBuffettandMunger’sprinciplesof

investingandrunningbusinessesfromwhatCharlieMungerwrote7:

Ourfiveconstituentbusinesseshavemoreincommonthanmightbe

notedbyacasualobserver:

1.Theyareallhigh-gradeoperationssuffusedtoaconsiderableextentwithbusinessideasofBenjamin

Franklin,mannedbyhigh-grade

peopleoperatingwithinalongtraditionemphasizingreliableand

effectiveservice.

2.Whenfunctioningproperly,eachbusinesswillusuallygenerate

substantialamountsofcash

notclaimedbycompulsoryreinvest-

mentinthesamebusiness.

BuffettandMungerhaveemphasizedtheimportanceofcashflows

beyondthecompulsoryreinvestmentinthesamebusinessbecausethese

cashflowscanhelpgrowth

ofBerkshireasawhole.

Conclusions

Inyourinvestments,youshouldfollowBuffett’sleadandstaywithin

yourcircleofcompetence,whichinBuffett’scaseisinsurance.Buffett’sE1C07

Date:Jan20,2010

Time:11:15am

in-depthunderstandingofinsurancebusinesshasservedBerkshirewell.

ItsinsurancebusinessGEICOhasdonewell,inpart,becauseBuffett

doesnotpayattentiontoshort-termearningsvolatility.Also,instead

ofborrowingintheopenmarket,Buffettuseslow-costfloat,orother

people’smoney,fromtheinsurancebusinesstoinvestinoracquireother

companies.

Date:Jan20,2010

Time:11:15am

Date:Jan20,2010

Time:11:57am

Chapter8

Reinsurance:Moreof

OtherPeople’sMoney

[W]eareaFortKnoxofcapital,andthatmeansvolatileearnings

can’timpairourpremiercreditratings.Thuswehavetheperfect

structureforwriting—andretaining—reinsuranceinvirtually

anyamount.Infact,we’veusedthisstrengthoverthepastdecade

tobuildapowerfulsuper-catbusiness.1

—WarrenBuffett

IfahurricanehitsMiami,aninsurancecompanywithalargenumber

ofpoliciesintheareawillbeinundatedwithclaimsandcouldgo

bankrupt.Othernaturalorman-madedisasterssuchastornadoes,

floods,fires,oilspills,andearthquakescanalsoresultinhugeinsur-

anceclaimsinshortorder.Toavoidafinancialdisaster,manyinsurance

companiestransfertheirriskstootherinsurance

companies,calledreinsurancecompanies.GeneralReCorporationisoneofthelargestreinsurancecompaniesintheworld,anditisownedbyBerkshireHathaway.

SizeMatters:Berkshire’sAcquisitionofGeneralRe

Asmallinsurancecompany—forthatmatter,anysmallcompany—

cannottakelargerisksevenwhentherewardsseemattractive.Forthis

Date:Jan20,2010

Time:11:57am

reason,largerinsurancecompaniesarelikelytobemoreprofitablethan

smallerones.ForBerkshireasawhole,sizeisadvantageousbecause

moreoftheinsuranceandreinsurancepremiumsandfloatcanbekept

in-house.Furthermore,Berkshiremayacceptmorereinsurancebusiness

fromotherinsurancecompanies.

In1998,BerkshireHathawayacquiredGeneralReCorporationfor

$22billion.ThisremainedBerkshire’slargestacquisitionuntilNovember

2009whenBerkshireannouncedplanstoacquireBurlingtonNorthern

SantaFefor$34billion.Berkshire’spremergershareholderequityof$31

billionincreasedby70percentinonefellswoop.Whenthemergerwas

announced,GeneralRewasthelargestprofessional

propertyandcasu-

altyreinsurancegroupdomiciledintheUnitedStates,anditconducted

businessinalmost150countries.Itwasoneofonlyfivenongovernmen-

talU.S.-basedfinancialinstitutionswithanAAAseniordebtratingfrom

Standard&Poor’s.

Was$22billionagoodpricetopay?Atthetimeoftheacquisition,

GeneralRe’sunderwriting(operating)profitswereaboutzeroanditwas

notexpectedtoearnanysuchprofits.Theseresultshadbeensimilarin

recentyears.Butthefirmwasgrowingfast,havingexpandeditsinsurancepremiumsatanannualrateof10.7percentinthe10-yearperiodending

in1997.SinceGeneralRe’sunderwritingprofitswereaboutzero,the

valueofunderwritingprofitspersecanbeassumedtobezero.However,

float,ortheamountofpremiumscollectedinadvancebutclaimsnotyetpaid,was$14.9billion.Asdiscussedinpreviouschapters,floatcanbe

valueddollarfordollarorevenhigherowingtopotentialgrowth.Buffetthasmadesimilararguments:“[T]houghourfloatisrecordedonour

balancesheetasaliability,ithashadmoreeconomicvaluetousthananequalamountofnetworthwouldhavehad.Aslongaswecancontinue

toachieveanunderwritingprofit,floatwillcontinuetooutranknet

worthinvalue.”2Iffloatcanbevaluedatabout$14.9billion,General

Re’stotalvaluewouldbeatleast$14.9billion.Sowhypay$22billion?

Theremayhavebeenintangibleassetssuchasreputationandsynergy

withotherBerkshireunitsthatIamunabletoassessbutthatBuffett

couldhave.Overall,itdoesnotappeartobeacheap

acquisitionthata

purevalueinvestorwouldendorse.InlinewithourdiscussioninChapter

6onBuffett-styleinvesting,Buffettprobablysawgrowthpotentialand

waswillingtopayapremiumforthatreason.

Date:Jan20,2010

Time:11:57am

Table8.1

GeneralRe’sRevenues,Float,andOperatingProfits

Operating

Operatingprofits

profits

asapercentageof

Revenues

beforetaxes

revenues

$14,909

$6,905

15,166

−$1,184

−17.1%

15,525

−1,224

−14.1

19,310

−3,671

−43.9

22,207

−1,393

−16.4

23,654

23,120

22,920

−334

−5.2

22,827

23,009

21,074

$72,544

−$6,235

−8.6

GeneralRe:1998–2008

Table8.1showsthatafterthe

acquisition,GeneralRe’sfloatincreased

from$14.9billionin1998to$21.1billionin2008,whichrepresentsan

annualgrowthrateofabout3.5percentoverthe10-yearperiod.Rev-

enues(premiums)grewfrom1998until2002buthavesincedeclined.

Overthepast10years,thegrowthinpremiumrevenuesisclosetozero.

Theoperatingprofitshavebeenvolatile,andtherehavebeensomelarge

losses.Wecanlearnseveralthingsfromthis.

Thehugelossof$3,671millionin2001reflectstheeffectofthe

9/11terroristattacks.Underwritinglossesfrom1999to2002werealso

large,muchgreaterthanintheyearsbeforebeingacquiredbyBerk-

shire.Whydidthishappen?In2002,Buffettmentionedthattheculture

atGeneralRewassuchthatpremiumswerenotbeing

writtenwith

asmuchdisciplineastheyshouldhavebeen.OnceBuffettrealizedthis

culturalproblem,GeneralRereducedtheamountofinsurancebeing

written.In2008,revenueswereonly71percentofwhattheywere

in2002.Sincethefloat-to-revenuesratioisabout4to1,floatisnot

Date:Jan20,2010

Time:11:57am

expectedtodeclineatthesamerate.In2008,floatwas95percentof

whatithadbeenin2002.Operatingprofitswerepositiveduring2006

to2008,whichisagoodsign.Basedonthefirstninemonthsofresults,

2009waslikelytobeevenastrongeryear.However,to

reallyevaluate

thequalityofunderwriting,itwilltakeusanother10yearsormore

becauselossesfromnewpoliciesdonotsurfaceimmediately.Whenesti-

matinganinsurancecompany’scostoffloat,youshouldtakealong-term

HowhastheGeneralReacquisitionturnedoutsofar?From1999

to2008,floatincreasedby$6.2billion,anincreasefrom$14.9billion

to$21.1billion.However,thecompanyincurredlargeoperatinglosses

duringthisperiod,alsoamountingto$6.2billion.Valuingfloatdol-

larfordollar,theincreaseinthevalueoffloatisnullifiedbyoperatinglosses.Therearesomeunderwritingprofitsnow,buttheyarenotsignificant.IapproximatethatBerkshirehasearnedjustaboutnothingfrom

itsinvestmentinGeneralRe

overthepast10years.Thegoodnewsis

thatthecumulative10-yearreturnontheS&P500indexfromyear-end

1998to2008wasabout–13percent.Thus,ifBerkshirehadinvested

thesameamountintheS&P500index,theresultswouldhavebeen

evenworse.Buffettisoptimisticaboutthefuture:“GeneralRe,our

largeinternationalreinsurer,alsohadanoutstandingyearin2008....

TodayGeneralRehasregaineditsluster....CharlieandIare...certainthat,withTad[Montross,CEO],GeneralRe’sfutureisinthebestof

hands.”3

WasbuyingGeneralReamistakeonBuffett’spart,oristheresome-

thingsystemicthatwecanlearn?Thisepisodeisagoodreminderthat

reportedprofitabilitymaynotreflectreality.Beforetheacquisition,GeneralRehadastellarrecord.Istudiedthe

preacquisition1997GeneralReannualreportcarefully.Theresultslookedverygood,andeveninhindsightIcouldnotseeanyprevailingcultureatGeneralRethatwouldleadtosubparunderwriting.GeneralRe’sgrowthinrevenueswasslowing,

butithadrecentlyacquiredotherinsurancecompanies.Itsprofitshad

increasedsteadily.Ingeneral,whenapubliccompanyisacquired,thereissomeprobabilityofhiddenproblems.ManyofBuffett’sacquisitionshave

beenfamily-controlledcompanies.MyguessisthatifGeneralRewere

afamily-controlledfirm,theculturalproblemmightnothaveoccurred

orwouldhavebeendiscoveredintimetopreventtheacquisition.

Date:Jan20,2010

Time:11:57am

GEICOversusGeneralReStrategiesonCapturingMarketShare

WhydoesGeneralRenotfocusonmarketsharethewayGEICOdoes?

ItseemsthatthetwoinsurancecompaniesunderthesameBerkshire

umbrellafollowdifferentifnotoppositestrategies.

GeneralRe’srevenueshavedeclinedforseveralyears,startingin2003.Itspolicyisnottowriteunprofitablepolicies.Ontheotherhand,GEICOmakesaseriouseffort

toincreaseitsmarketshareandspendslargesumsonadvertising.Thus,

unlikeGeneralRe,GEICOprobablyincursalossin

acquiringnew

customers.Thisdifference,onceagain,showsthatnotwocompanies

arealikeandtheyneednotfollowthesamestrategies.Thereasonsfor

thetwodifferentapproachesarethenatureofthecustomersandthe

amountofthepremiums.

InthecaseofGEICO,onceacustomerbuysautomobileinsurance,

heislikelytoremainacustomerforalongtimebecauseofinertiaandlowabsolutepremiumamounts.So,itmakessensetoworkhardtoattracta

customereveniftheinitial

costofdoingsoishigh.However,GeneralRewritesreinsurancepoliciestootherinsurancecompanies.Sincereinsurancepremiumamountsarelarge,itislikelythatGeneralRe’scustomers

donotsufferfrominertiaandshoparoundwhenareinsurancepolicyis

upforrenewal.Hence,repeatbusinesswillnotmaterialize

asitdoesin

thecaseofGEICO.Overall,itisnothighlybeneficialforGeneralReto

writeunprofitablepoliciestograbmarketshare.Berkshirehasanother

largereinsuranceunitthatisworthdiscussingbecauseitsprofitabilityissubstantiallydifferentfromthatof

GeneralRe.

BerkshireHathawayReinsuranceGroup

Berkshire’sthirdmajorandprobablythemostprofitableinsurancegroup,

BerkshireHathawayReinsuranceGroup,ismanagedbyAjitJainwith

astaffofonly31employees.

BuffetthaspraisedAjitJainlavishlyalmosteveryyearintheannuallettertotheshareholders.Inthemostrecent

annualreport,hewrites,“This[B.H.ReinsuranceGroup]maybeone

ofthemostremarkablebusinessesintheworld,hardtocharacterize

buteasytoadmire....Itfeaturesverylargetransactions,incrediblespeedofexecutionandawillingnesstoquoteonpoliciesthatleave

othersscratchingtheirheads.”4Onceagain,notwobusinessesarealike,

Date:Jan20,2010

Time:11:57am

Table8.2

BerkshireHathawayReinsuranceGroup’sRevenues,Float,and

OperatingProfits

Operating

Operatingprofits

profits

asapercentageof

Revenues

beforetaxes

revenues

$4,305

$2,382

−$256

−10.7%

−162

−3.4

11,262

−647

−21.6

13,396

13,948

15,278

16,233

−1,069

−26.9

16,860

11,902

23,692

24,221

$47,357

$4,273

eveniftheyareinthesameindustry.Thisisoneofthe

manyreasons

whyasimplecomparisonoffinancialratiosaloneisnotenoughtofind

goodstocks.Youneedtothinkaboutthecompany-specificbusiness,

acquirethemostknowledgethatyoucanaboutthebusinessandits

high-levelmanagers,thencomputeitsintrinsicvaluetomakebuyorsell

decisions.

Table8.2highlightsthefinancialperformanceofBerkshireHathaway

ReinsuranceGroupfrom1998to2008andcanbejuxtaposedagainst

theGeneralRedataintheprevioustable.B.H.ReinsuranceGroup’s

earningsarealsovolatilewithlossesin4outof10years.However,overthepast10years,B.H.ReinsuranceGrouphasproducedpretaxprofitsof

$4,273million(9.0percentofrevenues)incontrasttoGeneralRe’slossesof$6,235

million(–8.6percentofrevenues).GEICO’scorresponding

profitabilitynumberis7.5percent.

Tofurtherillustratetheargumentthatnotwobusinesseseveninthe

insuranceindustryarealike,Icomputefloat-to-revenuesforeachofthe

threemajorBerkshireinsurancebusinesses.GEICO’sfloatisonlyabout

Date:Jan20,2010

Time:11:57am

70percentoftherevenues,orthefloatisabouteightmonthsofrevenues.

ThisreflectsthefactthatmostofGEICOinsurancepoliciesarerelated

toautomobilesandarerenewedeverysixmonthsorthereabouts.Onthe

otherhand,asimilaranalysisofTables8.1and8.2shows

thatGeneral

Re’sandB.H.ReinsuranceGroup’sfloatsareequivalentto3and3.4

yearsofpremiums,respectively.Thisexampleillustratesthepointthat

financialratiosoftencharacterizethenatureoftheunderlyingbusinesses.

Aswepreviouslydid,assumingthatthevalueoffloatisbasically

dollarfordollar,B.H.ReinsuranceGroup’sfloathasincreasedinvalue

from$4.3billionattheendof1998to$24.2billionattheendof2008.

Inaddition,thecompanyhasgeneratedoperatingprofitsof

$4.3billion

whoseafter-taxvaluewithoutdiscountingisabout$2.8billion.Adding

$2.8tothecurrentvalueoffloatof$24.2producesavalueof$27.0

billion,whichisaconservativeapproximationtostudythegrowthrate

fromthevalueof$4.3billionin1998.In10years,B.H.Reinsurance

Group’svaluehasincreasedattheannualrateofabout20percent.Thisisremarkableforalargecompanyinalow-growthindustry.WhileBerkshire’sinsuranceandreinsurancebusinessesasawholehavedonevery

well,youshouldnot

generalizethistootherfirmsintheindustryunlessyouviewtheirCEOstobeoutstanding.Withthatinmind,Ipresent

twointerestingexamplesoflargereinsurancecompaniesonthevergeof

goingbankrupt.

FailureofRelianceInsuranceCompany

Areinsurancebusinessisnotnecessarilysaferthananinsurancebusiness.

Youmustlookatthekindsofreinsurancerisksacompanymaybetaking.

Hereisanexampleworthkeepinginmindifyouareplanningtoinvestin

areinsurancecompanystock.RelianceGroupHoldings

Inc.,a183-year-

oldinsurer,sufferedsuchhugelossesinitsreinsurancebusinessthatitsstockpricedroppedfrom$19persharein1998to$0.25in2000—aloss

of$2billioninmarketvalue.Inthiscase,workers’compensationliabilitywaspassedfromtheprimaryinsurerstoseveralreinsurers,

including

Reliance.Thereinsurersgotstuckwithlowpremiumsandpotentially

largeclaims.Asimplelessonfromthisisthatasinglelargemistakecanleadanestablishedreinsurancecompanyintobankruptcy.

Date:Jan20,2010

Time:11:57am

BerkshireHathaway,operatingthroughitssubsidiaryCologneRe,

alsowrotesomeofthe

reinsurancecontractsandtooka$275million

pretaxchargein1999.Fortunately,Berkshire’sshareofthisreinsurance

poolwasnotlarge.Whereas$275millionisalargesuminabsoluteterms,itwasonlyaboutone-fourthof1percentofBerkshire’smarketvalue.If

youplantoinvestinreinsurancecompanies,youshouldtrytofindout

ifthecompanyismakingconsciouseffortstoavoidlargelosses.Buffett

hasclarifiedthatgiventhediversifiedportfolioofinsurancepoliciesandthenatureofriskstaken,Berkshireisunlikelytofacealargeone-time

claimfromanyofitspolicies.AndBerkshirecaneasilyabsorbaclaim

worthseveralbilliondollarsasitdidfollowingthe9/11terroristattacks.

BuffettaptlycapturesBerkshire’sadvantages:

[W]esellpoliciesthatinsuranceandreinsurancecompaniespurchase

inordertolimittheirlosseswhenmega-catastrophesstrike....Whatyoumustunderstand,however,isthatatrulyterribleyearinthesuper-catbusinessisnotapossibility—it’sacertainty.Theonlyquestionis

whenitwillcome.5

Berkshire’sadvantagesincludeitssizeandconservativefinancing

policy.Lettheseattributesalwaysbeyourguidesforinvestingingeneral.

The2008–2009MarketCrashandAIG

AmericanInternationalGroup(AIG)wroteabout$84billionofinsur-

ancepremiumsin2008,comparedwith$26billionwrittenbyBerkshire.

Withastockpriceofabout$100persharein2000,itsmarketvaluewas

$260billion,muchlargerthanBerkshire.Butinearly2009,AIGwas

almostbankrupt,itssharepricearound$1.Whathappenedtosucha

greatcompany?Canthathappentoanycompany?

First,considerhowithappened.Therearemanypartstothis

puzzle,butoneaspectstandsout.AIGgotintoaninsurancebusi-

nessthatitthoughtitknewwell.AIGthoughtitwasinitscircleof

competence—insurance.Theinsuranceitprovided,called

creditdefaultswaps,wasagainstcorporationsdefaulting(usuallyasagroup)ontheirdebt.Whilecreditdefaultswapsareessentiallyinsurancepolicies,they

requirepostingofimmediatecollateralwhenlossesoccur.AIGfailed

Date:Jan20,2010

Time:11:57am

toconsidertheeffectofarecessiononmanycompaniessimultaneously

andthemaximumamountof

lossitcanface.Astheeconomyslowed

significantlyin2008,policyholders(calledcounterpartiesincreditdefaultswaps)demandedmanybillionsofadditionalcollateralthatAIGdidnot

have.Thefederalgovernmenthadtostepinwithanemergencyloan

toAIGasitbecameclearthatAIGmayhavetodeclarebankruptcy.By

May2009,AIGhadreceived$180billionfromthegovernmentinone

formoranother,aboutthevalueofallthegoldheldinFortKnox.It

appearsthatAIGdidnotknowwhatitwasdoingor

thattheemployees

responsibleknewbutgambledwithotherpeople’smoneyanyway.

Disasterscanstrikeanyinsurancecompany,ofcourse,because

unforeseencircumstancesoccur.Forexample,theSeptember11,2001,

attackontheWorldTradeCentercouldhavebeenfataltoGeneralRe.

Buffettwrites,“[H]adGenReremainedindependent,theWorldTrade

Centerattackalonewouldhavethreatenedthecompany’sexistence.”6

Eveniflargeinsurancecompaniesarebailedoutby

thegovernment,

theirbusinesscandryupandshareholderscansufferhugelosses.In

2009,largebondinsurersMBIAandAmback,amongmanyothers,fell

intothiscategory.

GrahamandBuffettadvocateconservativefinancing

becausewhen

companieshavetheabilitytoborrowalot,theysometimesdo.In

badtimes,highlyleveredcompaniessufferandcanevengobankrupt.

Similarly,wheninsurancecompaniesbecomeaggressive,theywriteeco-

nomicallyunsoundinsurancepolicies(becausetheycollectfloat,whichissimilartoborrowing),andinbadtimes,theysufferandcangobankrupt.

Howdoyouknowifacompanyisbecomingaggressive?Itisdifficult

toknowforsure.Buthereisahint.Risk-takingbehaviorofindividuals

islikelytobereflectedintherisk-takingbehaviorofthecompanies.Ininvestingininsuranceandothercompanieswherecomputationofearningsrequiressignificantestimates,youwillbebetteroffwithmanagers

whoarefinanciallyconservativeintheirpersonallives.

Conclusions

Attheendof2008,outofBerkshire’stotalinsurancefloatof$58.5

billion,GeneralReandBerkshireHathawayReinsurancecontributed

Date:Jan20,2010

Time:11:57am

$21.1billionand$24.2billion,respectively.Theselargesumsarevirtuallycostfree,buttheytrulybelongtotheinsuranceholdersorareother

people’smoney.Whenusingotherpeople’smoney,acompanyhasthe

addedresponsibilityofusingthatmoneyeffectively.Insituationswhen

otherpeople’s(your)moneyisbeingmanaged,oneshouldlookfor

extraordinarymanagerswiththehighestlevelofintegrity.

Itiseasyto

straywhenmoneyischeapanditisnotyourown,butitcanbevery

destructivetothecompany.

Date:Jan18,2010

Time:8:21pm

Chapter9

TaxDeferment:

Interest-FreeLoansfrom

theGovernment

SolongasWesco[aBerkshiresubsidiary]doesnotliquidate,

anddoesnotsellanyappreciatedsecurities,ithas,

ineffect,an

interest-free“loan”fromthegovernmentequaltoitsdeferred

incomestaxesontheunrealizedgains,subtractedindetermining

itsnetworth.1

—CharlieMunger

Youmayfinditdifficulttobelievethatattheendof2008,

BerkshireHathawayhada$10billioninterest-freeloanfrom

theU.S.InternalRevenueServiceandothertaxauthorities.

Accordingtomosttaxrules,neitheryounoranyoneelse

hastopaytaxes

onpapergainsonstocksuntilthosepapergainsareconvertedintoreal

gains.Forexample,Berkshire’sCoca-Colainvestment,purchasedabout

20yearsago,hasincreasedfromtheinitial$1.3billionto$9.1billion,butBerkshirehasnotyetpaidanytaxeson

thepapergainsof$7.8billion.

Thenonpaymentoftaxesisindirectlyaninterest-freeloanthatBerkshireenjoys.Thelongeryouwaittocaptureyourpapergains,thelongeryou

don’thavetopaytaxes.

Date:Jan18,2010

Time:8:21pm

ValueofBerkshire’s$10BillionInterest-FreeLoan

fromtheGovernment

WhatisthevaluetoBerkshireoftheinterest-freeloan?Wecanunder-

standthisusingasimpleexample.Assumethatyourmothergivesyou

$100interestfreeandsaysthatyoucankeepitforever.Sinceyouneed

notpayanyinterestandneednoteverpaythemoneyback,itisessen-

tiallyagift.Ifaninterest-freeloanisheldforever,itsvalueisthesameastheamountoftheloan.So,ifBerkshirecankeepthesecuritiesforever,

thevalueofthetaxdefermentis$10billion.Iftheholdingperiodis

morethan10years,thevaluewillbecloseto$10billion,say,$8billion.

AnotherwaytothinkaboutthisisthatifBerkshireearnsa10percent

annualreturnonthisinterest-freeloan,Berkshiremakesabout$1billionayearthatitwouldotherwisenotmake.

Aninterestingandsomewhat

dramaticdiscussionappearsinBerk-

shire’s1989annualreport.Buffettwrites2:

ImaginethatBerkshirehadonly$1,whichweputinasecuritythat

doubledbyyear-endandwasthensold.Imaginefurtherthatweused

theafter-taxproceedstorepeatthisprocessineachofthenext19

years,scoringadoubleeachtime.Attheendof20years,the34%

capitalgainstaxthatwewouldhavepaidontheprofitsfromeach

salewouldhavedeliveredabout$13,000tothe

governmentandwe

wouldbeleftwithabout$25,250.Notbad.If,however,wemadea

singlefantasticinvestmentthatitselfdoubled20timesduringthe20

years,ourdollarwouldgrowto$1,048,576.Werewethentocashout,

wewouldpaya34%taxofroughly$356,500andbeleftwithabout

$692,000.

Unlikemostmutualfundsthatbuyandsellfrequently,Buffettdoes

notengageinfrequenttrading.Buffett’sexampleshowsthatmutual

fundsthattradeoftencauseinvestorstopaymoreintaxesthaninvestorswhotradelessoften.Mostdiscussionsinthepopularpressonmutual

fundinvestingdonotmentiontheadvantagesfromtaxdeferment.Iftax

defermentwerediscussed,mostmutualfundswouldbeunattractiveto

tax-payingindividuals.

Date:Jan18,2010

Time:8:21pm

TaxDeferment:Interest-FreeLoansfromtheGovernment

Returnsona$10,000

Investmentin25Yearswith

andwithoutTaxDeferment

Let’sassumethatyouinvest$10,000inamutualfundthatisexpected

toearnthesamereturnastheS&P500index.Alsoassumethatallyourtaxescanbedeferreduntilyousellyourinvestment.Ifyouhadinvested

onJanuary1,1984,andheldthisinvestmentfor25yearsuntiltheend

of2008,yourinvestmentwouldhaveincreasedtoabout$103,500.This

equalsarateofreturnofabout9.8percentperyear.Youhavetopay

taxeswhenyoutakethemoneyoutattheendofthe

25-yearperiod.

Assumingthelong-termtaxrateof20percent,youwillpay$18,700in

taxesandyourinitialinvestmentwouldgrowto$84,800netoftaxes.

Figure9.1showsthisamount,$84,800,andcomparesitwithasec-

ondamountthatyourinvestmentwouldgrowuptoifyoupaidtaxeson

yourincomeeveryyear.Forcomparison,assumethatyourmarginaltax

rateis35percentincludingstateandlocaltaxes.Then,youwouldhave

earnedonly6.37percent(0.65×9.8percent)peryear,

andyourfinal

amountwouldhavebeenabout$46,800.Inthefirstcase,yourmoney

wouldhavegrownabout8.48times($10,000to$84,800)andinthe

secondcase4.68times($10,000to$46,800).Itseemstobeaverylarge

differencetome,andIdidnotevenconsiderthefactthatmutualfunds

alsochargeamanagementfee.Itisreasonabletoassumethatin25years,youwouldearnonlyhalfofwhatyouwouldotherwiseearnifyoucan

saveonfrequenttaxesandmoneymanagementfees.

Whydopeopletradesooftenorhavesomuchmoneyinvestedin

mutualfundsthattradeoften?Manypeoplewhoinvestinmutualfunds

dosobecausetheydonotfeelconfidentenoughintheirstock-picking

abilitiestomaketheirowninvestmentsandgiveinto

advicefrommutual

fundsalespeople.Theydonotthinkintermsofcompoundingand

100,000

$84,800

$46,800

50,000

Dollars

Amoutwithtaxdeferment

Amountwithouttaxdeferment

Figure9.1

FinalAmountwithandwithoutTaxDefermentfromInitial$10,000

InvestmentinS&P500from1984to2008

Date:Jan18,2010

Time:8:21pm

long-termreturnsoftenenoughandaretooquicktoselltotrytomake

aquickbuck(greed)oravoidlosses(fear).Also,thefactthatputting

yourmoneyintoamutualfundthattradesfrequentlyresultsinamuch

highertaxrateisnotthefirstpointmutualfund

salespeopleemphasize

intheirpitch.

Thelessonhereisthatyoushouldsearchforstocksthataregood

long-terminvestments.Ifyoudonothavetimetosearchforstocksor

ifyoudonotbelieveininvestinginindividual

stocks,investinindex

funds,notinactivelytradedmutualfunds.

Conclusions

Thelessonontaxdefermentandcompoundingteachestwothings.First,

itimplicitlysuggeststhatyoushouldstartinvestingearly.Ifyouaregoingtobe

leavingyourmoneyaloneforlongperiods,youwillwanttomake

yourinitialinvestmentasearlyaspossibletoallowforthemaximum

growthbeforeyouneedtopullyourmoneybackout.Second,donot

buyandsellyourinvestmentsfrequently.This

willcauseasubstantial

percentageofyourtaxestobedeferredandyourreturnstobehigher.

BuffettpracticestaxdefermentforBerkshireshareholders.Insteadof

constantlymakingtrades,buygoodstocksandgotothebeach.Ifyou

donotknowwhattobuy,buytheVanguard500IndexFundandhold

itforaslongasyoucan.

E1PART04

Date:Dec10,2009

Time:4:19pm

PartFour

SUCCESSINRETAILING,

MANUFACTURING,

ANDUTILITIES

BerkshireHathawayownsseveralcompaniesintheretailing,man-

ufacturing,andutilitysectors.Chapters10to13explorewhy

Buffettpurchasedthesecompaniesandwhathedoes

tocreate

theirsubsequentprofitablegrowth.

E1PART04

Date:Dec10,2009

Time:4:19pm

Date:Feb4,2010

Time:2:35pm

Chapter10

IfYouDon’t

KnowJewelry,

KnowYourJeweler

[T]herewasneveranyquestioninmymindthat,

first,Helzberg’s

wasthekindofbusinessthatwewantedtoownand,second,Jeff

wasourkindofmanager.1

—WarrenBuffett

In1989,BerkshirepurchasedBorsheim’s,ajewelrystoreinOmaha.

WhenIreadabouttheannouncementinthe

newspaper,Iwas

puzzled.Whyisthewell-knownvalueinvestorbuyingadazzling

business?Whereisthevalue?Later,Buffettexplainedthecostadvantage

ofBorsheim’s:“Weattractbusinessnationwidebecausewehaveseveral

advantagesthatcompetitorscan’tmatch.Themostimportantitemin

theequationisouroperatingcosts....JustasWal-Martsellsatpricesthathigh-costcompetitorscan’ttouchandtherebyconstantlyincreases

itsmarketshare,sodoesBorsheim’s.Whatworkswithdiapersworks

withdiamonds.”2

Date:Feb4,2010

Time:2:35pm

retailing,manufacturing,andutilities

ComparisonwithWal-Mart:CostAdvantage

Buffett’sanalogyisworthrepeatingbecauseitisnotconventionalwis-

dom:“Whatworkswithdiapersworkswithdiamonds.”Hispointisthat

inalmostanyindustry,costadvantageisimportant.

Costadvantageinthejewelrybusinessmaycomefromvarious

sources.First,thereisanadvantageinlocation:OmahaisalessexpensiveplacetooperateabusinessthanNewYork,andthiscanbeespecially

relevantduringeconomicdownturns.Overheadsaresmaller,period.

Keepingthisphilosophyinmind,mostWal-Martstoresarelocatedin

thesuburbs,notinexpensivecitycenters.Consequently,Wal-Marthas

slowlybuiltareputationofreliablylowprices.Second,onceacompany

orastorehasbuiltagoodreputation,itscostsgodown

evenmore.

Thishappensforavarietyofreasons.Forexample,itdoesnothave

toadvertisemuch.Spendinglessonadvertisinghelpsbringdownthe

costperunitofsales.Untilrecently,Wal-Martdidnotadvertisemuch

innewspapersandontelevision.Beyondeasilyidentifiablecostadvan-

tagessuchasadvertising,additionalcostadvantagescomefromsuperior

managerswhobuiltthereputationinthefirstplace.AsBuffettpoints

out,helikedJeffComment,themanager,whowas

runningHelzberg

Diamondsatthetime.BuffettdidnotjustmeanthathelikedJeffas

agolfbuddy.HelikedJeffforhisabilitiesasamanager.Goodman-

agersknowwhatqualityitemstobuyandinwhatquantitiestoorder.

Thisgivesthemacostadvantagethroughpurchasingandlowcustomer

returns.

Forbig-ticketitemssuchasjewelry,thereputationofthestoreand

itsmanagersalsohelpsgeneratehigherrevenuesand,hence,higherprof-

itability.Averageconsumersoftenfinditdifficulttodeterminethetruevalueofdiamondsandjewelry.Hence,trustplaysamajorroleinbuying

decisions.Theaveragecustomerwouldratherpay10percentmoreto

ensurethatthediamondsandpreciousmetalareofthehighestquality.Inthis

regard,Berkshire’snamehasprobablyalsohelpedincreaserevenuesatBorsheim’s.RegardingBorsheim’sCEO,Buffettwrites:“Inthesixyears

priortothemove,saleshaddoubled.IkeFriedman,Borsheim’smanag-

inggenius—andImeanthat—hasonlyonespeed:fastforward.”3When

youseeabusinessmanagedbypeoplelikeSamWaltonorIkeFriedman,

thebestactiontotakeistotrytopartnerwiththem.Buffettbelieved

Date:Feb4,2010

Time:2:35pm

inFriedman’sintegritysomuchthatheboughtthebusinesswithoutan

audit.“Ifyoudon’tknowjewelry,knowyourjeweler”makessensefor

anybusinessorstockyou

plantobuy.Thejewelersinthismaximare

thepeoplemanagingthebusiness.

Regardlessofhowmuchyouresearchacompany,youcannotlearn

enoughaboutitsfutureproducts,researchanddevelopment(R&D)

plans,newmarkets,alliances,corporategovernancepractices,andso

on.However,ifthecompany’smanagersare“goodjewelers,”youreally

donotneedtoinvestahugeamountoftimeininvestigatingthebusi-

ness.Tounderstandthemanagement,youhaveto

makeafewphone

callstolearnaboutcustomerservice;yourfamilyandfriendsmaytell

youabouttheirexperiences,andyoumaytrythecompany’sproducts.

Theimportanceofmanagementqualityisunderscoredinthefollowing

Berkshireacquisitions.

HelzbergDiamonds,BenBridgeJeweler,

andOthers

BerkshirepurchasedHelzbergDiamondsin1995.Theinspiringstory

ofthecompany’sgrowthrevealswhatBuffettlikestoseeinapotential

acquisition.Thisisnotonlyaboutthesuccessofthebusinessbutalso,

onceagain,aboutthepeople.Hereisthestoryofthepeoplebehind

HelzbergDiamonds.

MorrisHelzbergopenedthefirstHelzbergjewelrystorein1915.

HisyoungsonBarnettoftenworkedintheshoponSaturdays.When

hisfatherbecameill,Barnettbecameresponsiblefortheentireoper-

ationattheageof14.BythetimehisolderbrotherGilbertreturned

fromWorldWarItojointhebusiness,Barnetthadbecome

anexuber-

antbusinessman.Anaggressivepromoter,heranlargenewspaperads

toutingtheslogans“MeettheHelzbergBoys”and“WearDiamonds.”

Healsoofferedfreeairplanerideswithapurchase.By1925,Helzberg

hadexpandedsignificantlyandquicklybecameknownasaprominent

jewelerintheMidwest.

WhenBerkshirepurchasedHelzberg,ithad134storesscatteredall

overtheUnitedStates.Bythebeginningof2009,thenumberhadrisen

to270stores.BuffettexplainswhatledhimtoacquireHelzberg4:

Date:Feb4,2010

Time:2:35pm

InMay1994,aweekorsoaftertheAnnualMeeting,Iwascrossingthe

streetat58thandFifthAvenueinNewYork,whenawomancalledout

myname.Ilistenedasshetoldmeshe’dbeento,andhadenjoyed,the

AnnualMeeting.Afewsecondslater,amanwho’d

heardthewoman

stopmedidsoaswell.HeturnedouttobeBarnettHelzberg,Jr.,who

ownedfoursharesofBerkshireandhadalsobeenatourmeeting.

Inourfewminutesofconversation,Barnettsaidhehadabusiness

wemightbeinterestedin.Whenpeoplesaythat,itusuallyturnsout

theyhavealemonadestand—withpotential,ofcourse,toquickly

growintothenextMicrosoft.SoIsimplyaskedBarnetttosendme

particulars.That,Ithoughttomyself,willbetheendof

Berkshirewasmadetoorderforhim.Ittookusawhiletoget

togetheronprice,buttherewasneveranyquestioninmymindthat,

first,Helzbergwasthekindofbusinessthatwewantedtoownand,

second,Jeffwasourkindofmanager.Infact,wewouldnothavebought

thebusinessifJeffhadnotbeentheretorunit.BuyingaretailerwithoutgoodmanagementislikebuyingtheEiffelTowerwithoutanelevator.

YoumaynoticethateventhoughBuffettlikedthebusinessandthe

management,hedidnotwanttooverpayforit.Ashesaid,ittook

themawhiletogettogetheronprice.However,asBarnettHelzberg

said,“Buffettdidn’tchangeahairintheleadershipofHelzberg.”5This

statementbyHelzbergisahallmarkofBuffett’s

managementstyle.After

Buffettinvestsinacompanyoracquiresacompany,hedoesnottryto

influencethemanagement.Helooksforacompanythathasanexcel-

lentlong-standingreputationandsuperiormanagementalreadyinplace.

Helzberg’sthinkingaboutdevelopingasuccessfulbusinessissimilarto

Buffett’s:“BusinessisPeople.”6Thissoundssimple,butitisnotnecessarilyeasyforeverymanagertoimplement.Ifyoufindacompanywith

aSamWalton,don’tworryaboutwhetherhesellsdiapersordiamonds.

Youhavefoundagoodjeweler,andyoushouldthinkofbecominghis

partner.

Berkshire’sjewelrybusinesshasgrownsteadily,addingmorebusi-

nesseswithexcellentreputations.In2000,BerkshireacquiredBen

BridgeJeweler,achainof65stores.Thenumberofstoreshadrisen

to77byearly2009.EdBridgeandJonBridgewerethefourth-

generationowner-managersofahighlyreputedjewelrybusinessthat

hadgrownsteadilyundertheirleadership.EdBridge

calledBuffetton

Date:Feb4,2010

Time:2:35pm

arecommendationfrom

BarnettHelzberg.Hewasespeciallyimpressed

byBuffett’spreferencetoletthecurrentmanagementofhisacquisitions

operatewithlittleinterference.In2007,Berkshireacquiredtwogold

jewelrymanufacturers:Bel-OroInternationalandAurafinLLC.One

additionalpointtodrawfromBerkshire’sinitialpurchaseofBorsheim’s

andsubsequentexpansionsisthatthevariouscompaniesarekeptinde-

pendentofoneanotherintermsofmanagement.Hemadenoeffortto

mergehisjewelrycompaniesintoasingleentity.Overall,

Buffettseemstoemphasizethelong-termreputationofthebusinessanditsmanagement

quality.

Profitability:Berkshire’sJewelryBusinesses

versusTiffany&Co.

Inanybusiness,whatultimatelymattersis

profitability.UnderBerkshire,acquiredcompaniesareabletodoevenbetterthanwhattheywouldhave

doneindependentlybecauserisksarereducedandexpansionplanscan

beimplemented,possiblythroughBerkshire’sfinancialsupport.InTable

10.1,IpresentananalysisofBerkshire’sjewelrybusinessesfor1996to

1999.(Morerecentdataarenotavailable.)SalesrevenuesofBerkshire’s

jewelrybusinessesgrewfrom$392millionto$486million,a24percent

increase.Thistranslatesintoagrowthrateofabout7

percentperyear,agoodgrowthrateformaturebusinesses.However,operatingprofitswent

upsubstantiallymore,from$28millionto$51million,whichtranslates

into82percent,orabout22percentperyear.Similarly,profitability

oftheassetsemployed—that

is,thereturnonassets—increasedfrom

10percentto20percent.Theincreaseinreturnonassetsshowsthat

Berkshire’sjewelrybusinessesdidnotneedthesamelevelofinventories

andotherassetsperunitofsalesin1999thattheydidin1996.Given

thatBuffettemphasizesprofitability,IthinkthatBuffettinfluencedtheirfocusontheefficiencyoftheassetsemployed.

IuseTiffany&Co.asayardstickforcomparisonbecauseitisthe

premierjewelrybusinessintheUnitedStates.Ithasbeenoperatingsince1837andcommandsthegreatest

respectinthejewelryindustry.Itisalsohighlyprofitableandsuccessfulinmaintainingitsleadershipposition.IfwecomparetheprofitabilityofBerkshire’sjewelrybusinesseswiththat

Date:Feb4,2010

Time:2:35pm

Table10.1

ProfitabilityofBerkshire’sJewelryBusinessesComparedwith

Tiffany&Co.’s

Berkshire’sJewelry

Business

Revenues

Identifiableassetsatyear

Operatingprofitsbefore

Operatingprofitsasa

percentageofrevenues

Operatingprofitsasa

percentageof

identifiableassets

Tiffany&Co.

Revenues

$1,461

$1,169

$1,018

Totalassets

$1,343

$1,057

Operatingprofits

Operatingprofitsasa

percentageofrevenues

Operatingprofitsasa

percentageof

identifiableassets

ofTiffany’s,wewillbeputtingBerkshire’sjewelrybusinessesupagainstthebestintheindustry.Table10.1showsthetwosetsofdata.

Tiffany’srevenuesareaboutthreetimesthoseofBerkshire’sjew-

elrybusinesses.Inthefour

yearsfrom1996to1999,Tiffany’salso

increaseditsrevenuessubstantially,from$922millionto$1.46billion,

a58percentrise.Ultimately,itisnotthedollaramountofrevenues

orthedollaramountofoperatingprofitsthatmattersthemost.What

Date:Feb4,2010

Time:2:35pm

mattersisprofitability.Weshouldalwaysask:“Whatisthereturnonassets

employed?”ThelastrowofdatainthetableisthemostusefulforcomparingBerkshire’sjewelrybusinesseswithTiffany’s.In1996,Berkshire’sjewelrybusinesseslaggedbehindTiffany’sintermsofoperatingprofitasapercentageoftotalassets:10percentversus15percentforTiffany’s.

However,by1999,

Berkshire’sjewelrybusinesseshadachievedparity:

20percentversusTiffany’s19percent.Themainreasonforthissuc-

cessseemstobethatBuffettpickshigh-qualitymanagerstorunreputed

businessesandthenallowsthosemanagerstorunthose

businessesasif

theyownedthem.

Conclusions

Whiletheyareallretailjewelrystores,Borsheim’s,HelzbergDiamonds,

andBenBridgeJewelerarerunasseparatebusinessesundertheBerkshire

umbrella.Theprincipalreasonismanagerswhomadethosebusinessessuccessfulinthefirstplacebykeepingcostslowandcustomerssatisfied.

Hence,theirsuccessesarelikelytocontinueundertheexistingmanage-

ment.Remember,“Whatworksfordiapersworksfordiamondsandfor

otherbusinesses.”WhenBerkshireacquiresabusiness,itmaintainsthe

business’soriginalorganizationalstructuretosuitthemanagement,ratherthanrequiringthemanagementtoconformtoacommonorganization

structure.

Date:Feb4,2010

Time:2:35pm

Date:Jan20,2010

Time:11:19am

Chapter11

CompeteLikeMrs.B

There’snooperationinthe

furnitureretailingbusinessremotely

liketheoneassembledbyBerkshire.It’sfunformeandprofitable

foryou.1

—WarrenBuffett

Ihaveoftenaskedmyfriendsandcolleaguesabouttheirthoughts

oninvestinginfurniture

retailers.Notsurprisingly,mostofthem

considerthebusinessmundaneandhaveneverthoughtofinvesting

inone.In1983,Berkshireacquireda90percentinterestinNebraska

FurnitureMart,whichwasrunbyitsthen-ownerRoseBlumkin,

popularlyknownasMrs.B.WhydidBuffettpurchasethisbusiness?

Theanswerswegetfurtherstrengthenourconclusionsintheprevious

chapter.

KnowWhenNottoCompete:

NebraskaFurnitureMart

RegardingtheNebraskaFurnitureMartacquisition,Buffettwrote:

OnequestionIalwaysaskmyselfinappraisingabusinessishowIwould

like,assumingIhadamplecapitalandskilledpersonnel,tocompete

withit.I’dwrestlegrizzliesratherthancompetewith

Mrs.Bandher

Date:Jan20,2010

Time:11:19am

progeny.Theybuybrilliantly,theyoperateatexpenseratioscompeti-

torsdon’tevendreamabout,andtheythenpassontotheircustomers

muchofthesavings.It’stheidealbusiness—onebuiltuponexcep-

tionalvaluetothecustomerthatinturntranslatesinto

exceptional

economicsforitsowners.2

Clearly,themainreasonforthesuccessofNebraskaFurnitureMart

isthatitisrunbyincrediblemanagerswhoremainfocusedoncustomers

andcost.TheirphilosophyisnotverydifferentfromWal-

Mart’sphilos-

ophyof“Wesellforless.”Mrs.Bsummarizedherphilosophyas“Sell

cheapandtellthetruth.”3

NebraskaFurnitureMartcontinuedtodowellafteritsacquisitionby

Berkshireandisstilldoingwellunderthemanagement

ofMrs.B’schil-

drenandgrandchildren.Revenuesincreasedsteadilyfrom$100million

in1983tomorethan$300millionin1999.Sincethen,thecompany’s

salesdatahavenotbeenpubliclyavailable.NebraskaFurnitureMart

nowhasstoresinDesMoines,Iowa,andKansasCity,Kansas.Nebraska

FurnitureMartwasnotacquiredbecauseithadwonderfulproducts.It

wasacquiredbecauseithadwonderfulmanagers.In1996,Buffettwrote

ofMrs.B:“She’s103nowandsometimesoperateswith

anoxygen

maskthatisattachedtoatankonhercart.Butifyoutrytokeeppace

withher,itwillbeyouwhoneedsoxygen.”4OneBerkshirepractice

thatmayplayaroleinthecontinuityofexcellentmanagementisto

offerdesirableincentivestomanagers.InthecaseofNebraskaFurni-

tureMart,10percentofthestore’sownershipwaskeptintheBlumkin

family.

Inawalkaroundyourtown,youwillnodoubtseesomeincred-

iblebusinessesthathavebeenoperatingthereformanyyears.Besides

furniturestores,youmayfindafewrestaurants,grocerystores,bars,

bakeries,cafes,dry-cleaningstores,andpizzaparlors.Someofthem

maybelargeenoughtobepubliclytraded.Mostpeople

ignoresmall

businesses—theyaretooboringtobediscussedintheWallStreetJournaloronCNBC.PeterLynchdiscussestheimportanceofbuyingboringbut

well-runcompanies:“Ifacompanywithterrificearningsandastrong

balancesheetalsodoesdull

things,itgivesyoualotoftimetopurchasethestockatadiscount.”5Youshouldnothesitatetopartnerwithsuch

businesses.

Date:Jan20,2010

Time:11:19am

CompeteLikeMrs.B

R.C.WilleyHomeFurnishings

TheacquisitionofNebraskaFurnitureMartledBuffetttoanother

successfulfurnitureacquisition.Berkshireacquiredthefive-storeR.C.

WilleyHomeFurnishingsin

1995.Thenumberofstoreshassincegrown

steadilyandreached15by2008.NebraskaFurnitureMart’sIrvBlumkin

wasthemainpersonbehindthisacquisition.Buffettwrites,“Itwas

NebraskaFurnitureMart’sIrvBlumkinwhodidthewalkingaround

inthecaseofR.C.Willey,longtheleadinghomefurnishingsbusiness

inUtah.Overtheyears,Irvhadtoldmeaboutthestrengthsofthat

company.AndhehadalsotoldBillChild,CEOofR.C.Willey,how

pleasedtheBlumkinfamilyhadbeenwithitsBerkshire

relationship.”6

R.C.Willey’shistoryalsotellsussomethingaboutitslikelyfuturesuc-

cess.Fromasmallbusinesswithsalesof$250,000in1954,CEOBill

Childbuiltitintoa$257millionrevenueestablishment.

AsIdiscussedinthepreviouschapter,Buffettrespectsindependence.

InthecaseofNebraskaFurnitureMartandR.C.Willey,hesaidthat,liketheCEOsofotherbusinesses,themanagersofthesetwobusinesseswould

operateautonomously.Thephilosophybehindthis—worthrepeating

manytimesover—isthatitiseasiertohandlealargenumberofcom-

petentmanagersiftheyaregivenindependence.Ifcompetentmanagers

arenotgivenindependence,theyarelikelytoleave.Buffettwrites,“IfIhaveonepersonreportingtomeandheisalemon,that’sonetoomany,

andifIhavemanagerslikethosewenowhave,thenumbercanbealmost

unlimited.”7

StarFurnitureandJordan’sFurniture

TheNebraskaFurnitureMartandR.C.Willeystoriescontinuedto

unfoldasBerkshire

HathawayacquiredStarFurniturein1997.When

BuffettaskedR.C.Willey’sCEOaboutfurnitureindustrystandouts,

oneofthenameshegavewasStarFurniture,afive-storeretailer.Severalyearslater,StarFurniturebecameavailable,andBuffettappearedhappy

toacquireit.“AswasthecasewithBlumkinsandBillChild,Ihadno

needtocheckleases,workoutemploymentcontracts,etc.IknewIwas

dealingwithamanofintegrityandthat’swhatcounted.”8Ofcourse,in

Date:Jan20,2010

Time:11:19am

additiontoexcellentmanagement,Buffettsawopportunityforgrowth.

Andthecompanyhasgrown

steadilyeversince.In2009,therewere10

StarFurniturestores.

Excellentmanagerscontributenotonlythroughthesuperiorprof-

itabilityoftheirbusinessesbutalsothroughtheirideas.Theybecome

extravoiceswhocanadvise

youonhowtodobusinesswithintheir

field.AndBuffettlistenstothem.TheideatopurchaseJordan’sFurni-

turealsocamefromthemanagersofotherfurniturestoresthatBerkshire

alreadyowned.BuffettexplainshowhecameacrossJordan’sFurni-

ture:“IhavepersistentlyaskedtheBlumkins,BillChild,andMelvyn

Wolffwhetherthereareanymoreouttherelikeyou.Theirinvariable

answerwastheTatelmanbrothersofNewEnglandandtheirremarkable

furniturebusiness,Jordan’s.”9

InthecaseofJordan’s,thecompanynotonlysellsfurniture;italso

presentscustomerswithadazzlingentertainmentexperiencecalledshoppertainment.ParentscangotoJordan’sandsimultaneouslyfindanewottomanandtaketheirkidsoutforanafternoonoffun.Arewelikelyto

seeinnovationsfromoneunit,say,Jordan’s,transferredtotheotherunits?

Asweknow,Buffettdoesnotinterfereintheday-to-daymanagement

ofthevarioussubsidiaries,buthedoesprovideallpossibleopportu-

nitiesforinteraction.Aslongasmanagershaveincentives

toimprove

profitability,theywilladopttheinnovationsthataresuitabletothem

butavoidtheonesthatarenot.Thisismoreefficientthanrequiringallthefurniturestorestoadoptpracticesthathavebeensuccessfulforone

ofthem.

CORTBusinessServices

HereisanothertwisttoBerkshire’sfurniturebusiness.CORTisnota

furniturestoreinthesamemannerasNebraskaFurnitureMart.CORT

isaleadingnationalproviderofrentalfurniture,accessories,andrelatedservices.CORTwasacquired

in2000byBerkshire’ssubsidiaryWescofor

$385million.InJanuary2008,CORTagreedtoacquireRoomservice

Group,asimilarsmallerfirmintheUnitedKingdom.InNovember

2008,itacquiredabusinessdivisionofAaronRentsandexpandedto

severalnewmarkets.CORThasgrownminimallyinthepasteightyears

Date:Jan20,2010

Time:11:19am

CompeteLikeMrs.B

(revenuesof$395millionin2001to$410millionin2008),probably

becauseofmarketconditions.

However,CORThaspromise,asCharlieMungerwrites:

CORThascontinuedtomakeseveralselectiveacquisitionssinceit

waspurchasedbyWesco,anditisbelievedthatCORTisnowbetter

positionedtobenefitfromjobgrowthandanycorrespondingeco-

nomicexpansion....CORTiswellpositioned...duenotonlytoits

nationalpresenceandliquidity,butalsobecause

thebusinessreputation

ofBerkshireHathawaygivesitentréetotheofficesofmanyprospective

customers,andthusacompetitiveadvantage.10

ThestoryofCORTtellsusthatnotallofBerkshire’sacquisitions

growfast.However,theyare

allmanagedwithalong-termpointofview.

Thisapproachtoslowandsteadygrowthresemblestheonewesawfor

GEICO.CORTisbuildingitsreputationnowandwillprobablybecome

aggressiveincapturingmarketshareandacquiringweakercompetitors

whentheeconomyisdownbecauseitdoesnothavetoworryabout

quarter-over-quarterprofits.Lowcost,reputation,andfinancialstrengtharekeystolong-termsuccessinfurnitureandsimilarbusinesses.

Conclusions

Youmightthinkthatother

thanafewbusinesseslikejewelrythatwe

discussedinthepreviouschapter,consumersdonotcaremuchabout

thereputationofabusiness.Thatisnotso.Thereisatleastoneimportantreasontocareaboutthereputationofafurniturestore.Howoftendo

youseeadsforfurniture

stores’going-out-of-businesssales?Theyseem

omnipresent.Whenafurniturestoregoesoutofbusiness,customers

oftenlosetheirdeposits,warranties,andreturnprivileges.Itisdifficulttorebuildareputationonceitisdestroyedbysuchevents.LevitzFurniture,forexample,hasfiledfor

Chapter11bankruptcythreetimes:1997,2005,

and2007.Businessesrunbyreputablefirmsormanagersrarely,ifever,

gooutofbusiness.Insteadtheycontinuetogrow.Wheneverpossible,

investwithreputablemanagersrunningreputablebusinesses.

Date:Jan20,2010

Time:11:19am

Date:Jan20,2010

Time:11:36am

Chapter12

WhyInvestin

UtilityCompanies?

Thoughtherearemanyregulatoryconstraintsintheutility

industry,it’spossiblethatwewillmakeadditionalcommitments

inthefield.Ifwedo,theamountsinvolvedcouldbelarge.1

—WarrenBuffett

In2000,BerkshireHathawayinvested$1.7billiontoacquire

MidAmericanEnergy(MEC)withWalterScottasitspartner.MEC

isanelectricutilitybasedinIowawithoperationsintheUnited

StatesandtheUnitedKingdom.Withthisacquisition,Berkshirecame

toownamajorutilitycompanyandenteredintoanewindustry.Invest-

mentsintheutilitysectoraregenerallyregardedaslowrisk,whichis

somethingBuffettalwayslooksforinapotential

acquisition.Butwhat

elsecouldhavepromptedBuffetttobreakintotheutilityindustry?

SimilaritybetweentheMECand

OtherAcquisitions

TheMECacquisitionhasseveralfeaturesincommonwithBuffett’s

prioracquisitionsinthefurnitureandjewelryretailingbusinesses.First,129

Date:Jan20,2010

Time:11:36am

retailing,manufact

uring,andutilities

customersbuymostoftheirfurnitureandjewelrylocally,justasthey

doelectricity.Second,theseindustriesarealllikelytocontinuetogrowbecauseofincreasesinpopulationandstandardsofliving.Third,Buffettonceagainemphasizestheimportanceofmanagementinthis

acquisition.

TalkingaboutWalterScott,MEC’sthenlargestshareholder,andDavid

Sokol,theCEO,Buffettwrites:“IfIonlyhadtwodraftpicksoutof

Americanbusiness,WalterScottandDavidSokolaretheonesIwould

chooseforthisindustry.”2

WhydoesBuffettfocusonmanagement?GoingbacktoBerk-

shire’sinvestmentinNebraskaFurnitureMart,notmanypeoplewould

havepredictedthatBerkshirewouldacquirefurniturebusinessesallover

thecountry.Thesubsequentacquisitionsweremadewiththehelpof

NebraskaFurniture’smanagement.Similarly,severaljewelrybusinesses

wereacquiredaftertheinitialacquisitionofBorsheim’s.Likewise,Berk-

shirehopedtobenefitbyusingtheMECmanagement

selectfollow-up

acquisitions.

Buffettwasnotbuyingacheapcompanyasapurevalueinvestor

wouldliketodo.Berkshirepaid$35.05pershareforMEC,whichitself

atthetimewasgrowingfastthroughacquisitions.Over

theprior10

years,itstotalassetshadgrownfromlessthan$500milliontoabove

$10billion,atwentyfoldincrease.Revenueshadgrownalongthesame

lines.Theaverageearningspersharefortwoyearsbeforetheacquisitionwas$1.74,givingMECan

acquisitionprice-to-earnings(P/E)of20,

comparedwiththelong-runS&P500P/Eaverageofabout16.Other

metricssuchasmarket-to-book(M/B)ratiosimilarlydidnotsuggest

thatthecompanyfittheprofileofatraditionalvalueinvestment.

Moststateregulatorsallowutilitiestoearnareturnonequityof

about10percent.MidAmericanwasearningaboutthesamerateof

returnatthetimeitwasacquiredbyBerkshire.Utilities,regulatedor

otherwise,donotearnahighrateofreturnonequity,but

mostofthem

earnasteadyrateofreturn.Thus,theyareusuallyconsideredtobelow-

riskinvestments,buttheirlong-runstockmarketreturnsareonlyatad

belowthecorrespondingreturnsfromindustrials.Fromdataavailablefor

1993to2008,compoundedannualreturnsontheDowJonesUtilities

indexincludingdividendsare7.8percent(233percentover16years)in

comparisonwith8.6percent(276percentover16years)fortheDow

JonesIndustrialAverage.(PriordataonUtilitiesindex

withdividends

Date:Jan20,2010

Time:11:36am

factoredinarenotavailable.)

Overall,itseemstomethatBuffettinvestedintheutilityindustrytoearnareasonablerateofreturn,somewhat

betterthantheratehecouldearnbyinvestinginmedium-orlong-term

bonds.Inthelongrun,theremayalsobeprofitablegrowthopportunities

becauseofoutstanding

managersBerkshirepickedupwiththeMEC

acquisition.Finally,utilitieswouldallowBuffetttoinvestalargesumofmoneyovertime,amuch-neededoutletforBerkshire’sever-growing

insurancefloat.Let’sconsiderBuffett’sacquisitioncriteriainconnectionwithMEC.

FourNonpriceAcquisitionCriteria

“Webuygoodcompanieswithoutstandingmanagementandgood

growthpotentialatafairprice,andwe’rewillingtowaitlongerthan

someinvestorsforthatpotentialtoberealized.This[MEC]investment

isrightinoursweetspot,”writesBuffett.3Notethefourcriteria,in

additiontoprice,mentionedbyBuffett:

1.Outstandingmanagement

2.Goodcompany

3.Goodgrowthpotential

4.Patience

TheMECacquisitionprovidesagoodexampletodiscussthese

criteria.

OutstandingManagement

BuffettrecallshowhestartedthinkingabouttheMECdeal:“Walter

casuallyaskedmewhetherBerkshiremightbeinterested

inmakinga

largeinvestmentinMidAmerican,andfromthestarttheideaofbeing

inpartnershipwithWalterstruckmeasagoodone....Waltercharac-

teristicallybackeduphisconvictionswithrealmoney:Heandhisfamily

willbuymoreMidAmericanstock....Walterwillalsobethecontrollingshareholderofthecompany,andIcan’tthinkofabetterpersontohold

thatpost.”4Giventhesestatements,thekeyelementforthepostacqui-

sitionsuccessofamergeristhequalityofmanagement.Inthecaseof

Date:Jan20,2010

Time:11:36am

MEC’sacquisition,WalterScottparticipatedbyinvesting$300million

ofhisownfundsthatalsosignaledhisconfidenceinthefutureofthe

company.

Itisnoteasytoidentifyoutstandingmanagement.Buffettempha-

sizesalongtrackrecordofsuccess,attimesaverylongtrackrecord.

Hehasmentionedthatthereshouldbenomandatoryretirementagefor

CEOsbecauseexperienceonlymakesthembetter.Mrs.BatNebraska

Furnitureremainedactivewellpasttheageof100.OtherBerkshire

managersolderthan80yearsofageincludeA.L.Ueltschi,

chairman

ofFlightSafety,andCharlieMunger,vicechairmanofBerkshire.AsI

discussedearlier,high-qualitymanagersalsofuelgrowththroughacqui-

sitions,astheyknowwhattobuyintheirindustry.Theirhumancapital

isnotreflectedonthecompanybalancesheet,andhenceBuffettiswill-

ingtopayareasonableprice-to-earnings(P/E)ratiowhenhebuysa

companythatcomeswithexcellentmanagement.

GoodCompany

Buffettdoesnotsay“great

company”;hesays“goodcompany.”The

definitionofagoodcompanyisalsonoteasytopindown.Inmymind,

agoodcompanyisonethathasgivensatisfactoryreturnsoninvestment

andislikelytogivesatisfactoryreturnsfortheforeseeablefuture.This

conditionisclearlymetbyMECasthecompanyformostpartisregulated.Buffetthasalsosaidthatsignificantbarrierstoentryaredesirablecompanycharacteristics,andinthecaseofMEC,thatconditionismet

becauseutilitiesrequirelargesumsofmoneyforpowerplants.Buthis

mainfocusinacquisitionsseemstobetoplaceagoodcompanyinthe

handsofexcellentmanagementwithfullsupportfromBerkshire.That

managementmaytransformagoodcompanyintoagreatcompany.Ifit

doesnotbecomeagreatcompany,thereturnswill

stillbesatisfactory.Ifthecompanyisalreadyrecognizedasagreatcompany,thestockprice

maybetoohighforittobeaBuffettinvestment.Ontheotherhand,the

potentialincreaseinthevaluefromtransferringagoodcompanyintoa

greatcompanyisenormous.5

AsshowninTable12.1,MidAmerican’sreturnonassets(earnings

beforeinterestandtaxes/totalassets[EBIT/TA])in2008and2007is

5.4percentand5.5percent,respectively,oranaverageof5.45percent.

Date:Jan20,2010

Time:11:36am

Theoverallconclusionsaresimilarifweusealltheavailabledata.Ifweincludeonlytangibleassets(inotherwords,ifweexclude

accounting

Goodwill),theaveragereturnis6.35percent.Ialsoestimatedreturn

onequity,whichturnsouttobeabout8percent.6Ignoringaccounting

Goodwill,thereturnonequityisabout13percent.Sincedetaileddata

onreplacementcostsofproperty,plant,andequipmentarenotavailable,

myguessisthatthereturnonequityissomewherebetween8percent

and13percent,oranaverageof10.5percent.Thisreturniscloseto

whattheregulatorsoftengranttheutilities.Consistent

goodreturnsareatell-talesignofagoodcompany.

Likemostutilities,MidAmericanhasalargeamountofdebt.At

theendof2008,MidAmerican’sdebtwas$20.1billionagainst$41.6

billionoftotalassets,orabouthalfoftotalassets.DoesitgoagainstBuffett’s

philosophyofmaintainingalowfinancialleverageandmake

MidAmericanabadcompany?Themainreasonforapreferencetoward

lowfinancialleverageingeneralistoavoidfinancialstress.However,

well-managedutilitiesgeneratesteadycashflows

andhavelargeamounts

ofplantassets.Suchcompaniescanavoidfinancialdistressbyremaining

focusedontheirbusiness.Utilitiessometimesgetintotroubleprimarily

becauseofineptmanagementasEnrondidwhenitenteredintohuge

derivativecontracts.Also,debtissuedbyMidAmericanisnotguaranteed

byBerkshire.Overall,ahighlevelofdebtatMECdoesnotseemtobe

aconcern.

GoodGrowthPotentialandPatience

Youmighthavenoticedthat

Buffettdoesnotcite“excellentgrowth

potential.”Onceagain,ifacompanyhasexcellentgrowthpotential,

themarketpriceislikelytoalreadybetoohighfortheinvestmentto

beaBuffettinvestment.Ontheotherhand,whenacompanyhasno

growthpotential,smallchangesintechnologyordemandforitsprod-

uctsmaycreatesignificantdiseconomiesrequiringthecompanytoshut

down.Nordosuchcompaniesattracttalentedemployees.Buffettrefers

toinvestinginacompanywithlittletonogrowth

potentialasa“cigar

butt”approachtoinvesting.Suchinvestmentsdonotofferhighlong-

termgainsjustascigarbuttsdonotoffermuchlong-termsmoke.Thus,

goodgrowthpotentialisahealthyacquisitioncriterion.

Date:Jan20,2010

Time:11:36am

Intheutilitysector,thegrowthpotentialforgoodcompaniesappears

promising,butaninvestor

mayhavetowaitforalongtimetorealizeanyactualgrowth.Specifically,newlawswillultimatelyallowunbundling

ofthegeneration,transmission,anddistributionfunctionstraditionally

performedbyutilitiesinoneunit.ThisunbundlingintheUnitedStates

willbesimilartothatintheUnitedKingdom,andMECshouldbenefit

greatlyfromitsexperienceintheUnitedKingdom.Butitwillnot

happenquicklybecauseitisapoliticalprocess.Intheinterim,Berkshirewillcontinuetoearnareasonablerateofreturn.

Table12.1showsthatMidAmerican’stotalassetshavemorethan

tripledto$41.57billionineightyears.Howdidthisgrowthoccur?It

appearsthatthepresumedlow-riskcharacteristicoftheutilityindustry

appliesonlytotheregulatedsector.Theunregulated

sector,domi-

natedbyfirmssellingelectricityandnaturalgasintheopenmarket,

isnotaslowriskastheregulatedsector,owingtothehighlevelof

financialleverage.Therefore,acquisitionopportunitiesarisewhencom-

paniesgetintotroublebecauseutilitycompaniesarehighlylevered.

OpportunitiesforBerkshiretoinvestintheenergysectorappeared

in2001and2002inthewakeofEnron’sbankruptcyandproblems

atotherenergycompanies.Berkshirepurchased

NorthernNaturalGas

pipelinefromDynegyfor$1.9billionandanothergaspipeline,Kern

River,fromtheWilliamsCompaniesfor$950million.In2006,Berk-

shireinvested$5.2billioninPacifiCorp.MidAmericanisalsogrowing

organically.From2006to2008,MidAmerican’scapitalexpenditurein

excessofdepreciationwas$6.7billion.Overall,therearegoodgrowth

potentials.

Youarenotlikelytoearnhighratesofreturnbyinvestinginautility.

Thebesttimetoinvestinautilityisprobablywhenautility’sbookreturnonitsequitygoesdown,affectingthestockpricesnegatively.Thiscan

occurwheninputpricesofcoal,gas,andthelikegoup,whencustomer

demandgoesdown(perhapsresultingfromeconomicslowdown),or

wheninterestratesgoup.Autilitywouldbeagoodvalueinvestment

then.Ofcourse,youshouldinvestinonlyhealthycompanieslestyou

loseyourinvestmentcompletelywhenacompanyisnotabletosurvive

theslump.Sinceutilitiesgenerateareasonablerateof

returnonequity

overthelongrun,alowreturninoneperiodislikelytobounceback

toahigherreturninsubsequentperiods.

Date:Jan20,2010

Time:11:36am

$11,681

$12,626

$14,177

$18,435

$14,862

$19,168

$15,597

$19,904

Holdings)

Energy

$16,037

$20,193

$30,942

$36,490

$10,644

(MidAmer

Sector

$33,917

$39,508

$12,628

Energy

$36,290

$41,570

$13,971

millions.

Berkshir

(EBIT)

Assets

plant,

amounts

assets

equipment,

assets,

Goodwill

EBIT/T

Dollar

Date:Jan20,2010

Time:11:36am

Conclusions

Berkshire’sacquisitionshavebeenforthemostpartsuccessful,probably

becauseofBuffett’semphasisonthequalityofmanagementandkeeping

thecurrentmanagementinplaceafterthemerger.Unlessyouarein

apositiontoclearlyforeseethesuccessofthemergedcompany,you

shouldavoidinvestingincompaniesthatareacquiringothercompanies.

Otherthanprice,youshouldaskatleastfourquestions

whenevaluating

anacquisitionsituation:Isthequalityofmanagementexcellent?Isita

goodcompany?Isthegrowthpotentialgood?Anddoestheacquirer

havepatience?

Date:Jan20,2010

Time:11:43am

Chapter13

HighProfitsin

Honest-to-Goodness

Manufacturing

Companies

Thecompany’s[Scott

Fetzer’s]successcomesfromthemanage-

rialexpertiseofCEORalphSchey—ThereasonsforRalph’s

successarenotcomplicated.1

—WarrenBuffett

ScottFetzerhasbeenaBerkshireHathawaysubsidiarysince1986

andmanufacturesorsells

suchwide-rangingitemsasutilitytree

vehicles,brushlessDC(directcurrent)anduniversalmotors,

Ginsuknives,WorldBookencyclopedias,Kirbyvacuumcleaners,and

professionalcleaningproducts,amongothersmallindustrialandcon-

sumeritems.

RalphE.Schey’sleadershipinsalesmanshipandmanagementwas

instrumentalinScottFetzer’ssuccessbeforeitwasacquiredbyBerkshire.

WhenScheyjoinedScottFetzerin1974,ScottFetzer’sstockpricewas

$8pershare.Tenyearslater,itsoldfor$62ashare.Atonetime,Ivan

Date:Jan20,2010

Time:11:43am

Boesky,acorporatebuyoutexpert,offeredtobuythecompany;andat

anothertime,thecompany’smanagementtriedtotakeitprivate.Both

thoseattemptsfailed,andBerkshireHathawaypurchasedthecompany

in1986for$61pershare,orabout$315million.Itwasacquiredafter

itssignificantgrowthinprioryearsunderRalphSchey’smanagement.

Untilhisretirementin2000,Scheymanagedthecompanyandproduced

highreturnsforBerkshire.

ScottFetzer’sSuccess

Table13.1showsthatforthefirstnineyearsafterBerkshireacquiredthecompany,ScottFetzerearnedatotalof$555millionandpaiddividends

of$635milliontoBerkshire.Therateofdividendpayments,onaver-

age,was22percentperyear

onBerkshire’sinitialinvestment.Earnings

grewsteadilyduringthisperiod.Whilerevenuesgrewattherateof

Table13.1

ScottFetzer’sEarningsandDividends

ReturntoBerkshireasa

PercentageofInitialInvestment

Earnings

Dividends

Earnings

Dividends

$125.0

Average

Date:Jan20,2010

Time:11:43am

HighProfitsinHonest-to-GoodnessManufacturingCompanies139

about4percentperyear,reaching$1billionin1994,earningsgrewat

about8percentperyear—aratethatseemsremarkablegiventhatallthe

companiesintheScottFetzergroupwerefromseeminglyold-fashioned

industries.

Althoughdetaileddataonearningsanddividendsarenotavailable

after1994,dataonoperatingearningsbeforetaxesareavailablefrom

1996until2002.AnanalysisofthosedatashowsthatthegroupofScott

Fetzercompaniescontinuedtodowell,althoughgrowthseemstohave

slowedsince1996.Basedonnumbersfromoperatingearnings,netearn-

ingsseemtobeabout$78millionperyear,which

translatesintoarate

of25percentperyearonBerkshire’sinitialinvestment.Overall,Scott

Fetzerhasbeenaremarkableinvestmentandcontinuestogeneratehigh

returns.

HowdidScottFetzerdosowellwhenmanycompanies

fromtra-

ditionalindustriesdidnotsurvivethecompetitionorfaceddeclining

profitability?YourunderstandingofScottFetzerwillhelpyoufindothercompaniesthatarepubliclytradedandfollowsimilarprinciples.

Companiesintraditionalor

old-fashionedindustriestypicallyface

decliningprofitability—soitisimportantformanagementtoavoidthe

temptationtoplowbackearningsintothecompany.Essentially,managers

needtoremembernottothrowgoodmoneyafterbad.From1986to

1994,totalearningswere$555.4million,butmostwerenotplowedback

intoScottFetzer.Instead,theywerepaidtoBerkshireintheformof

dividends.Intheso-calledold-fashionedindustries,highgrowthisnot

thenorm;growingeitherinternallyorthroughgood

acquisitionsisnot

easy.SocreditgoestoScheyandBuffettfornotexpandingsimplyfor

thesakeofexpanding.Ifyounoticeacompanythathasgoodcashflows

butwhosemanagersexpandthecompanybyacquiringothercompanies

orbyinternalgrowthofassets,youneedtoinvestigateitcarefully.

HowdoesBuffettaccomplishexemplarybehaviorfromhisman-

agers?Beyondpickingtherighttypeofpeople,thekeytosuccessmay

becarefullydesignedCEOcompensationcontracts.The

focusshould

beonprofitabilityandnotontotalprofits,whichdisregardsthecapitalbase.InthecaseofScottFetzer,Scheycouldhaveeasilygeneratedeven

higherlevelsofearningsifcashflowshadbeenplowedbackintothe

company.However,therate

ofreturnoninvestmentwouldhavegone

downandwouldnotbeoptimumforBerkshireasawhole.

Date:Jan20,2010

Time:11:43am

LestwethinkthatScottFetzer’sgrowthhasbeeninappropriately

deemphasized,weshouldnotforgetthatBuffettcanusethedividends

receivedinanywayhewants.ThecapitalallocationjobforBerkshireas

awholeisinBuffett’shands.Inthatsense,growthfromthedividends

receivedfromScottFetzercanoccurinanothercompany,givinghigher

ratesofreturntoBerkshireshareholders,whoaretheultimateownersof

ScottFetzer.Abriefexaminationofothersimilar

Berkshiresubsidiaries

ispresentednext.

ShawIndustries,Marmon,andMcLane

SeveralotherBerkshiresubsidiariesarealsofromhonest-to-goodness

traditionalindustries.WegetlikeinsightsfromthewayBuffettmanages

thesesubsidiaries.InTable13.2,Ipresenttheprofitabilitynumbersofonesubsidiarybecauseitisarelativelyrecentacquisition,anditsmajornumbersareavailablefromvariousBerkshireannualreports.ShawIndustries

isaleadingmanufactureranddistributorofcarpetsandrugsforresiden-

tialandcommercialuse.Berkshireacquired87.3percentofthecompany

in2001andtheremaining12.7percentin2002.Intotal,Berkshirepaid

$2.4billion.2

Shaw’srevenuesandearningsclimbedsteadilyfrom2001to2006but

declinedin2007and2008asthehousingmarketcollapsed.(Dividend

numbersarenotavailable.)IdentifiableassetsalsoincreasedasthedemandforShaw’sproductsroseduringtheboominghousingmarket.Interms

ofreturnonBerkshire’sinvestmentof$2.4billion,theaveragelevelof

annualreturnfrom2002to2008isabout15percentafteraccountingfor

taxes.Thisiscertainlyaveryhealthyreturnbecausetheinvestmentin

Shawshouldbeconsideredrelativelysafefromalong-termperspective.

Itisdifficulttoimaginethatthemarketforcarpetswillgo

awayand

thatawell-managed,dominantcompanywillnotremainprofitablefor

alongtime.

InthecasesofbothScottFetzerandShaw,theCEOsinchargeatthe

timeoftheacquisitionswerenotreplaced.RalphScheyat

ScottFetzer

continuedastheCEOfor14moreyears,andRobertE.Shawcontinued

astheCEOforsixmoreyears.Neitherofthemleftthecompaniesthey

managedforanotherposition,butretired.

Date:Jan20,2010

Time:11:43am

HighProfitsinHonest-to-GoodnessManufacturingCompanies141

Table13.2

ShawIndustries:ProfitabilityandGrowthafterBerkshire’s

AcquisitionofShaw

Earningsbefore

Earnings

taxesasa

Earningsbeforetaxesas

Identifiable

percentageof

before

apercentage

assetsat

identifiableassets

Revenues

ofrevenues

year-end

atyear-end

$4,090

$1,619

Average

Dollarsamountsinmillions.

In2008,Berkshireacquired60percentofMarmonHoldings,which

consistsof130manufacturingandservicebusinessesthatoperateinde-

pendentlywithin11diversebusinesssectors.Theproductsrangefrom

nutsandbolts,wire,andcabletoshoppingcartsandrailroadtankcars.

Theremaining40percentwillbeacquiredinfutureyearsforconsider-

ationtobebasedonthefutureearningsofMarmon.

Fromlimiteddata

thatareavailable,Isurmisethatprofitabilityishighlysatisfactoryatabout10percentoperatingincomeontangibleassets.

IalsoexaminedsimilarnumbersforMcLaneCompany,whichwas

acquiredbyBerkshireinMay2003.McLaneisoneofthe

nation’slargest

wholesaledistributorsofgroceriesandnonfooditemstoconvenience

anddiscountstores.Theafter-taxreturnontheinitialBerkshireinvest-

mentof$1.5billionhasbeenabout10percentperyear,onaverage.For

2008,earningsbeforetaxeswere$276million,whichisabout18per-

centbeforetaxesorabout11percentaftertaxes.ChancesareitsearningswillgrowwithtimeevenwithoutadditionalBerkshireinvestment.One

reasonforitsgrowthpotentialisthat,whenMcLanewasaWal-Mart

subsidiary,itwasnotviewedasanindependentdistributorbyWal-Mart’s

competitors.Manyofthepotentialcustomerswouldthennotbuyfrom

Date:Jan20,2010

Time:11:43am

McLane.However,asaBerkshireunit,itwillnothavethatimpediment

togrowth.Overall,whenacompanyisrunwell,theprofitabilityinbusi-

nessesfromtraditional

industriesdoesnothavetobelow.Asamatteroffact,Buffett’ssuccessmaycomepartlyfromthefactthathismanagers

doanoutstandingjobinmanagingseeminglyold-fashionedcompanies.

Conclusions

Themainingredientbehindthesuccessofcompaniesin

traditional

industriesisthepresenceofcompetentCEOswhomighthavemade

themsuccessfulinthefirstplace.TopraisetheCEOofShawIndustries,

Buffettwrites:“Anymanwhocanstartfromabsolutescratchinatough,

competitiveindustryandbuilda$5billionbusinessissomeoneIwantto

bepartneredwith.”3Asaninvestorlookingtoinvestincompaniesthat

havebeenaroundforawhile,youshouldgiveconsiderableimportance

tothequalityofmanagement.Tojudgethe

qualityofmanagement,

ShawCEORobertShawsays,“Investorscanlookatourtrackrecord

andgetonthetrainorgetoff.It’sthatsimple.”4Soitallboilsdowntotrackrecord;findCEOswhohaveagood—andlong—trackrecord.

E1PART05

Date:Dec10,2009

Time:12:21pm

PartFive

DIVERSIFICATION,

ANDWHENTOSELL

WarrenBuffett’sconceptofriskfrominvestingincommon

stocksisdifferentfromwhat

istaughtinbusinessschools.

Hisideasondiversificationandwhentosellarealsovery

insightfulandworthspendingsometimethinkingabout,evenifyou

havestudiedthesetopicsfromotherperspectivesbefore.Chapters14to

17aredevotedtothese

issues.

E1PART05

Date:Dec10,2009

Time:12:21pm

Date:Jan18,2010

Time:9:14pm

Chapter14

RiskandVolatility:How

toThinkProfitably

aboutThem

[W]edefinerisk,usingdictionaryterms,as“thepossibilityof

lossorinjury.”1

—WarrenBuffett

Whatdoesthewordriskmean?Thinkaboutit.Becauseof

theU.S.governmentguarantees,U.S.Treasurybillsand

bondsareconsideredtobetheleastriskysecuritiesaround

theworld.Inthiscontext,

riskimpliesdefaultriskordownsiderisk.

Followingthislineofthinking,corporatebondsareriskierthanU.S.

bonds,commonstocksareriskierthancorporatebonds,andoptionsare

riskierthancommonstocks.However,whenacademicsmentionthat

commonstocksareriskierthancorporatebonds,theyinvariablyimply

thatcommonstockshaveahigher“beta.”Insimpleterms,betameasureshowstockreturnsarecorrelatedwithmarketreturns:Thehigherthe

correlation,thehigherthebeta,withtheaveragebetaofallstocksbeingnormalized

to1.0.However,inmostresearchstudies,betahasnotbeenfoundtobeausefuldefinitionforpredictingcommonstockreturns,

especiallyforindividualstocks.2So,academicsarestilltryingtodevelop145

Date:Jan18,2010

Time:9:14pm

risk,diversification,andwhentosell

bettermeasuresofrisk.Inthemeantime,asanindividualinvestor,you

arebetteroffignoringbetaforpickingindividualstocks.Youshould

insteadcarefullydifferentiatebetweenthedownsideriskandtheupside

potential.Attheveryleast,youshouldknowwhatyou

meanbythe

wordrisk.

Avagueunderstandingofriskisadangerousthing.Considerthe

well-knowncaseoftheOrangeCountybankruptcy.In1994,Orange

County,California,lostmorethan$1.5billion.Stateand

localgov-

ernmentsaregenerallyconsideredtobesomeofthemostconservative

investors.HowdidOrangeCountylosesuchahugeamount?Inthiscase,

theanswerlayinamisunderstandingoftheriskembeddedinderivative

securities:callandputoptionsandfuturescontracts.Inthemindsofsomeadministrators,thesederivativesecuritiesweresupposedtohavereduced

riskandenhancedreturns.However,theydidjusttheopposite.Aclearer

understandingofriskwouldhavehelpedOrangeCountyavoidthishuge

loss.IfOrangeCounty’sadministratorshadaskedabouttheprobability

andpotentialmagnitudeofloss(downsiderisk),theyprobablywould

havemadebetterdecisions.3Inyourinvesting,youshouldalwaysask

thosequestions.

RiskandReturn:HoldingPeriod

WarrenBuffettsuggeststhatreturnsfromquartertoquarter,oreven

yeartoyear,arenotveryimportantifthereturnsinthelongrunare

predictable.Volatilityofreturnsintheshortrunshouldnotbethemain

criterionforassessingrisk.Whatmattersisthereturnattheendoftheinvestmentperiod.Assumethatyouinvest$1,000ina30-yearTreasury

bondyielding5percent.Ifyourinvestmenthorizonis30years,youwill

earn$50ininterestperyear,plustheprincipalof$1,000attheendof30

years.However,themarketpriceofthe30-yearbondwillchangefrom

monthtomonthdependingonthemarketinterestrate,whichcould

createsignificantshort-termvolatility.Ifyouhavea30-yearinvestmenthorizon,shouldyoudefinethemonthlyvolatilityofbondpricesasrisk?

No.Theinvestmentisrisk-freesofarasthepaymentsareconcerned

innominaldollars.Considerthesame30-yearbondinvestmentfrom

theperspectiveofapersonwithaone-yearinvestmenthorizon.This

Date:Jan18,2010

Time:9:14pm

RiskandVolatility:HowtoThinkProfitablyaboutThem

investorcanloseasignificantamountifinterestratesrisebecausethe

pricesoflong-termbonds

fallasinterestratesrise.Inearly2009,the30-yearTreasurybondsdeclinedinpriceby20percentwhentheinterest

rateswentupbyabout1.5percent.

Let’smoveontostocksandreturnvolatility.Assumethataninsur-

ancecompanyhas

underwrittenalargenumberofhurricaneinsurance

policiesinFlorida.YouareprobablyalreadythinkingofBerkshire’sinsurancebusiness.Theinsurancecompanywillshowhighprofitsintheyears

Floridaisnothitbyamajorhurricane.Sincethestockmarketusually

focusesontheshortterm,youshouldnotbesurprisedifthecompany’s

stockenjoyshighreturnsinthoseyears.Butduringayearinwhicha

majorhurricanehitsthestate,profitswillgodownandthestockprice

couldbebiddownsubstantially.“However,

Berkshire’smanagementis

willingtoacceptvolatilityinreportedresults,providedthereisarea-

sonableprospectoflong-termprofitability,”writesBuffett.4Aninvestorwhorecognizesthataone-timeeventmaynotaffecttheunderlying

long-runriskprofileofthe

companyislikelytoinvestmoreinagood

insurancecompanywhenthestockpricegoesdown.

Themainlessontotakeawayfromthisdiscussionisthatthereis

aninteractionbetweenthelengthoftheholdingperiodandrisk,espe-

ciallyifyouthinkofriskasdownsiderisk.Thisappliestobothbondsandstocks.Ifstockreturnsfromoneperiodtoanotherwerestatisticallyindependent,thelengthofthehorizonwouldnotbeimportant.However,

thereisampleempiricalevidencethatstockvolatilityinthelongrunislowerthanvolatilityintheshortrun.Thus,thelengthofthe

investmenthorizonshouldbeanimportantconsiderationforaninvestor.

VolatilityOffersOpportunities

Aninvestorwhoviewsvolatilityasriskwillbetemptedtoavoidvolatilestocks,whichmaynotbetherightinvestmentapproach.Indeed,Buffett

suggestsjusttheopposite:“Infact,atrueinvestorwelcomesvolatility.”5

Asanexample,considervolatilityandfirmsize.Smallercompaniesare

usuallymorevolatilethanlargercompanies,probablybecauseasmall

numberofbuyandsellorderscandramatically

changethestockprices

ofsmallercompanies.Butsmallcompaniesneednotbefundamentally

Date:Jan18,2010

Time:9:14pm

risky,especiallywhenyouknowalotaboutthespecificcompaniesyou

plantoinvestin.Opportunitiesaremorelikelytoariseinsmallercom-

paniesthaninlargercompanies.Buffetthasexpresslysaidthatifhe

hadasmalleramountofmoneytomanage,hewouldbeabletogen-

eratehigherreturns.SincetheBerkshireinvestmentportfolioishuge,

Buffettrestrictshimselftoinvestinginlargecompanies.However,if

youfollowanindustrycloselyenough,youshould

notignoresmaller

companies.

Increasedvolatilitydoesnotimplyincreasedriskbecausethereare

manyfactorsthatcancausevolatilitythathavenothingtodowithrisk.

ProfessorRobertShillerofYaleUniversityhasoften

arguedthatthe

stockmarketistoovolatiletobeeasilyexplainedbyrationalityalone.

Heconcludes,“Priceschangeinsubstantialmeasurebecausetheinvest-

ingpublicenmassecapriciouslychangesitsmind.”6Usually,afteran

earningsannouncement,acompany’sstockpricebecomesmorevolatile.

Thestockpriceisalsomorevolatileafterastocksplitbecausethepricepersharedecreases.Suchariseinvolatilitydoesnotnecessarilymean

thatthestockhasbecomemorerisky.Volatilityalsoincreaseswhen

theFederalReserveannouncesinterestratesorwhenothermacroeco-

nomicdataarereleased.Mostcompanyfundamentalsarenotaffected

bythesenewsitems,andyoushouldbuymoreofyourfavoritestocks

whenever“Mr.Market”iswillingtosellthemtoyouat

alowerprice

becauseofmarketvolatility.InOctober1974,theDowJonesIndustrial

Average(DJIA)wasbelow600afterhavingdeclined40percent,and

whenForbesaskedBuffetthowhecontemplatedthestockmarket,heshotback,“Likeanoversexedguyina

harem.Thisisthetimetostart

investing.”7

OpportunitiesfromtheSharpDeclineof1987

Therearemanypotentialreasonsforsharpdeclinesinstockprices,and

unlessyouarefairlycertainaboutthereasonforthe

decline,youshouldnotincreaseyourinvestmentinstockssimplybecausetheirpriceshave

declined.Acarefulsearchforareasonwillkeepyoufromcatchinga

fallingknife.Thedeclineofabout20percentonOctober19,1987,is

usuallyattributedtotheso-

calledportfolioinsuranceeffect,whichrequiredE1C14

Date:Jan18,2010

Time:9:14pm

manyinstitutionalinvestorstosellpartoftheirholdings

aspricesfell,whichinturnpushedpricesdownfurther.Wasthisjustified?Adetailed

examinationofthefundamentalsmayprovideasatisfactoryanswer.

Priceshadbeengoingupsteadilysincethemiddleof1982,when

theDJIAsoaredfrombelow800toahighof2,722in

August1987,an

increaseof240percentinfiveyears.Whilepredictingthemarketisnexttoimpossible,manyinvestorswerefeelinguncertainbecauseinterest

ratesonlong-termbondshadincreasedfromaround7.5percentto10

percentinamatterof

months.Atthesametime,themarketP/Eratio

washoveringaround22fromalowofaround10in1982.Generally,the

relationshipbetweeninterestratesandtheP/Eratioisinverse—thetwo

moveinoppositedirections—yetthistimearound,theP/Eratiowas

increasingasinterestratesweregoingup.Untilpricessuddenlycame

crashingdown.

EvenifyoucouldnotpredictthedownfallofOctober1987,you

wereprobablytemptedtostartinvestingaggressivelywhenpricesbecame

reasonableafterthedownfall.Inrecognizingthatthemarketwasready

forreinvesting,wehavethebenefitofhindsight.Buthistoryteaches

usthatwhenpricesrapidlygodown,theprobabilityoffindinggood

businessesorstocksatlowerpricesgoesup.Buffett

investedheavilyin

Coca-Colastockin1988inthewakeofthe1987marketcorrection.

Althoughthestockmarketinthiscaserecoveredinlessthantwoyears,itcouldhaveeasilytakenlonger.Justaswecannotforeseeacomingcrash,

weshouldnotfeel

comfortablepredictingaquickrecovery.

ASlowDeclinein1973–1974and2008–2009

During1973–1974,pricesdeclinedslowly,fromtheDow’shighof1,057

in1973toalowof577in1974—adropofabout45percent.Inpercent-

ageterms,thedeclinein1973–1974wasmoreseverethanthedeclinein

1987.Whydidthisoccur,andwasitpossibletoknowatvariousstagesifanopportunetimetoinvesthadarrived?BuffettnotedinOctober1974

thatitwastimetostartinvesting.Onceagain,withhindsight,wecan

allconcludethatlate1974certainlywasagoodtimetostartinvesting.

However,itseemsthatmostinvestorshadbeguntoinvestearlierthan

that.ThemarketP/Eratioattheendof1973wasalreadyarounda

Date:Jan18,2010

Time:9:14pm

reasonable12.Howcouldyouhaveknownthatyoushouldwaitalmost

anotherfullyearfortheP/E

ratiotofalltoalowofaround7?Thereisnowaytotimethemarketperfectly.Itisextremelydifficulttoknowwhen

priceshavebottomedout.Themainlessonthatwecanlearnfromthe

variousbearmarketsisthatitisimpossibletodevelopageneraltheory

aboutthecausesofbearmarketsbecausetherearedifferentcausesfor

everydecline.Themarketin1973–1974declinedprimarilybecauseof

thesimultaneousrecessionandincreaseintheinflationrate.TheArab

oilembargoinlate1973didnothelpmatters.Although

priceshad

declinedsubstantiallyin1973,noendtotherecessionwasinsightfor

awhile.

Whentherestoftheworldwasfearfulofinvestinginthestock

market,Buffettinvested$10.6millioninWashington

Postinthewake

ofthemarketdecline.Atthetime,thisamountedto21percentall

ofBerkshire’scommonstockinvestmentsinunaffiliatedcompanies.He

writes,“Weboughtallofourholdingsinmid-1973atapriceofnotmore

thanone-fourthofthethenper-sharebusinessvalueoftheenterprise.”8

WashingtonPostpricecontinuedtodeclineforanotheryear.Itillustratesthepointthatitisnotpossibletopickthepricebottomperfectly.By

mid-1974,astherecessionwasfinallygivingwaytooptimism,theoil

embargowaslifted,andtheFederalReserveloweredthefederalfunds

ratefrom8percentto7.75percent,andadditionalratecutsfollowed.

Thepricesfinallybouncedback.

In2009,theyearofthiswriting,theDowhasbeenaslowas7,500,

downfromapeakofover14,000just18monthsearlier.TheUnited

States,Europe,andJapanhavebeeninseriousrecessionsandgrowthin

ChinaandIndiahasslowedconsiderably.Themaindifferencebetween

the1973–1974declineandthecurrentrecessionisthat

thereisno

increaseininflationandinterestratesarelow.TheDowreboundedto

about10,000byNovember2009.Isthisagoodbuyingopportunity?

Noonecanbesure.Ipersonallyboughtsomeearlierandamstillbuying

alittlebit,butitisnosurethingthatwewillseeaquickturnaround

to14,000again.However,ifyouhavea10-yearinvestmenthorizon,it

seemslikeagoodtimetobuystocksinyourfavoritecompanies,withthe

Dow10,000.Betweenthethirdquarterof2008andthe

secondquarter

of2009,Berkshireinvestedalargesumofabout$18billioninvarious

Date:Jan18,2010

Time:9:14pm

preferredstocksandnotesofGoldmanSachs,GeneralElectric,Wrigley,

DowChemical,andSwissRe.Inaddition,inNovember2009,Berk-

shireannouncedplanstoacquireBurlingtonNorthernSantaFewhich

willconstituteitslargestacquisitionever.Theseinvestmentsseemtohavebeeninfluenced,inpart,bythemarketdecline.

MoreonDownsideRisk

Thebestwaytoavoidfinancialcatastropheistounderstanddownside

riskwell.Ifpossible,youshouldcompletelyavoid

stocksthathavea

largedownsiderisk.Downsideriskisnotjustadefaultriskforbondsorbankruptcyriskforstocks;youshouldalsoincorporatetheriskofalargedeclineinacompany’smarketvalueowingtoadversedevelopments.

Forexample,acompanyinvestinginmortgage-backed

securitiesmay

seealargenegativeeffectonitsstockpricesifhousingpricesfall.Whenhousingpricesaregoingup,stockpricesofsuchcompaniesmayalso

goup.Theymayappeartobegoodbuyingopportunities,butnotethat

downsideriskisalsogoing

upatthesametime.Asanotherexample,

considerbuyingstocksonmargin.Adeclineinthestockmarketmay

resultinamargincallthatmayrequiresellingoffthesecuritiesatatimewhenbuyingismoredesirable.Aninvestorwhohasthoughtaboutthe

downsideriskcarefullyismorelikelytoavoidinvestingonmarginand

avoidruininthelongrun.

Largepubliccorporationsdonotdefaultoften,butsometimesthey

do.Somelargecompanieshavesuddenlygonebankrupt(forexample,

EnronandWorldCom),andtheirstockholdershavelosttheirinvestments

completely.Inearly2007,BearStearns’stockpricewas$150pershare,

butthecompanywassoldtoJ.P.Morganforjust$10pershareayear

later.Asaninvestor,youshouldtakethisintoaccount.

Ingeneral,you

shouldbeespeciallycarefulininvestinginhighlyleveragedcompanies.

Atleastcomparetheirfinancialleveragewiththecorrespondingindustry

leverage,andavoidinvestingalargepercentageofyournetworthinto

highlyleveragedcompanies.

Earlier,wetalkedabouttheriskofinflationthatcanbeseriouseven

incountriesliketheUnitedStates.Theproblemwithinflationisnot

Date:Jan18,2010

Time:9:14pm

inflationitself.Theproblemsarisefromtheunforeseenhardshipsfor

thosewhoarenotpreparedforasubstantialfallinthepurchasingpower

oftheirsavingsorfortheeconomysheddingjobs.Buffettsays,“Inour

opinion,therealriskaninvestormustassessiswhetherhisaggregate

after-taxreceiptsfromaninvestment(includingthosehereceiveson

sale)will,overhisprospectiveholdingperiod,

givehimatleastasmuchpurchasingpowerashehadtobeginwith,plusamodestrateofinterest

onthatinitialstake.”9

Toavoidinflationrisk,youcaninvestininflation-adjustedTreasury

securitiesortheso-calledTIPs.Afterall,youareprobablynotinvestingin

Treasuriesforhighreturns.Youcanalsoavoidsomeinflationriskby

owningrealassets.Forexample,itmakesalotofsensetoownyourown

house.Ifyouhaveamortgage,afixed-ratemortgageisbetterbecauseit

allowsyoutoavoidthelargesurprisesthatcanresultfrom

avariablerate.

Inmyopinion,youshouldpayoffyourmortgageassoonaspossibleso

thatyouhavethesecurityofowningyourownhome(andyourmonthly

expensesdonotincludeamortgagepayment)intheeventyouloseyour

job.Ifpossible,youshouldtrytoacquiresomeotherrealestate;maybe

somefarmlandsothatyoucanlivethereandgrowyourownfoodifthings

reallygosouth!Finally,youshouldnotignoreshort-terminvestments

inmoneymarketsbecausetheyareliquid,andtherates

usuallyadjustas

inflationrises.Overall,safetyfirstandliquidityaregoodrulesthatpeopleoftenforgetwhenthegoingisgood.Berkshirehasalwaysmaintained

highliquidityandlowfinancialleverage.Shouldn’tyou?

Anotherdownsideriskisthe

declineinthevalueofthedollar.The

valueoftheU.S.dollaragainstothercurrenciesmaydecline,whichmay

affectyourconsumptionifyoutravelabroad.Tosomeextent,youcan

avoidthisriskbyholdingsomeothercurrencies;ChineseandEuro-

peanmoneyarelogicalchoicesinthissituation.Itisworthsummarizing

Buffett’soutlineonhowtothinkaboutrisk.Hewrites10:

Thoughthisrisk[inowningstocks]cannotbecalculatedwithengi-

neeringprecision,itcaninsomecasesbejudgedwithadegreeof

accuracythatisuseful.Theprimaryfactorsbearinguponthisevalua-

tionare:

1.Thecertaintywithwhichthelong-termeconomiccharacteristics

ofthebusinesscanbeevaluated;

Date:Jan18,2010

Time:9:14pm

2.Thecertaintywithwhichmanagementcanbeevaluated,both

astoitsabilitytorealizethe

fullpotentialofthebusinessandto

wiselyemployitscashflows;

3.Thecertaintywithwhichmanagementcanbecountedonto

channeltherewardfromthebusinesstotheshareholdersrather

thantoitself;

4.Thepurchasepriceofthebusiness;

5.Theleveloftaxationandinflationthatwillbeexperiencedandthatwilldeterminethedegreebywhichaninvestor’spurchasing-powerreturnisreducedfromhisgrossreturn.

Thesefactorswillprobablystrikemanyanalystsas

unbearablyfuzzy

becausetheycannotbeextractedfromadatabase.Butthedifficulty

ofpreciselyquantifyingthesemattersisnotinsuperableanddoesnot

negatetheirimportance.JustasSupremeCourtJusticePotterStewart

founditimpossibletoformulateatestforobscenitybutnevertheless

asserted,“IknowitwhenIseeit,”investors—inaninexactbutuse-

fulway—can“see”therisksinherentincertaininvestmentswithout

referencetocomplexequationsorpricehistories.

Conclusions

Whenyouthinkthatthereisalargedownsideriskininvestingina

company,youshouldbeespeciallyvigilantevenifexpectedreturnsare

high.Ahighlyleveragedbalancesheetisoneindicatorofhighdownside

riskinacompany.Evencountriesthatborrowlargeamountsofmoney

arenotsafe:Russiadefaultedonitsloansin1998.Ifyouhadinvested

inRussianbonds,youwouldhavelostheavily.Inparticular,LongTerm

CapitalManagement,thelargesthedgefundatthe

time,lostbillions

ofdollarsasaresultoftheRussiandefaultandalmostwentbankrupt.

SinceevenacountrythesizeofRussiacangetintotrouble,clearlyyou

shouldneverthinkofanycompanyas“toolargetofail.”Byeliminating

orseverelylimitingyourinvestmentsincompanieswithlargedownside

risks,youshouldbeabletoavoidthehugelossesemanatingfrommarket

volatility.Ontheotherhand,marketvolatilitymaycausegoodcompa-

nies’stockpricestogodownintheshortrun,givingyou

goodbuying

opportunities.

Date:Jan18,2010

Time:9:14pm

Date:Jan20,2010

Time:11:52am

Chapter15

WhyHoldCash:

LiquidityBrings

Opportunities

[K]eepinmindthatmostofthevalueofourconvertiblepre-

ferredsisderivedfromtheir

fixed-incomecharacteristics.That

meansthesecuritiescannotbeworthlessthanthevaluethey

wouldpossessasnon-convertiblepreferredsandmaybeworth

morebecauseoftheirconversionoptions.1

—WarrenBuffett

Topreserveprincipalandpossiblyinvestinmoreprofitableoppor-

tunitieslater,BuffettkeepsasignificantportionofBerkshire’s

totalassetsincash,short-termgovernmentsecurities,andpre-

ferredstock.Eveninadversesituations,theseinvestments

generally

safeguardthevalueoftheprincipalamount.Attheendof2008,Berk-

shirehad$24billionincashorcashequivalents,or12percentof

totalassets,initsinsurancebusinesses.Ithadanadditional$27bil-

lioninfixed-maturitysecurities,abouthalfofwhichareingovernment

securities.

Date:Jan20,2010

Time:11:52am

LiquidityandOpportunities

Beyondsafety,thereareatleasttworeasonswhyBerkshiremaintainsa

largeamountofcashandshort-termsecurities.First,

Berkshirecaninvestlargesumsofmoneyquicklywheneveragoodinvestmentopportunity

arises.Anopportunityarosein2002whenDynegyneededtosellits

16,600-milepipeline—theNorthernNaturalGasCompany—toBerk-

shirefor$928million,a

steepdiscountonthe$1.5billionthatDynegy

hadpaidonlyafewmonthsearlier.Inmanyothercases,suchasbuying

an80percentstakeinIscarfor$4billionin2006,Berkshiremadethe

dealquicklywithoutgoingtoanybanks.Obviously,ahighlevelofcash

isnotmaintainedbecauseitisagoodinvestmentperse.Itismaintainedandallowedtobuildupbecauseofpaucityofgoodinvestmentopportunities.Youshouldnotfeeltemptedtoinvestyourcashunlessyouhave

goodinvestmentopportunities.

During2008,Berkshire’scashandcashequivalent

decreasedfrom

$37billionto$24billionmainlybecauseBerkshireinvestedinWrigley,

GoldmanSachs,andGeneralElectricpreferredstocks.Berkshirecould

nothavemadetheseinvestmentswithoutliquidassetsthatitcould

accessquickly.Yetanotheropportunityarosein2008whenConstel-

lationEnergywasabouttogobankrupt.Berkshirewasabletoinvest

$1billionimmediatelyandmadeanofferwithinthedaytoacquirethe

entirecompanyfor$4.7billion.Thedealwasstruck

withabreak-up

clause,assuchdealsare.Subsequently,Constellationreceivedahigher

bidandBerkshiredidnotcompetetoacquirethecompany.However,

theoriginalinvestmentandthebreak-upfeeledtoa$1.1billionprofit

toBerkshire.

Thesecondreasonformaintainingliquidityistoattractbetter-

paying—ormoreprofitable—customers.Berkshirecanchargehigher

premiumsthanotherinsurersbecauseitcanfulfilllargeinsuranceclaimsmoreeasily.Intheworldofinsurance,

BuffettcomparesBerkshirewith

FortKnox.Nooneeventhinksaboutthepossibilityofaliquidityprob-

lematBerkshireresultingfromlargeclaims.Berkshirewasabletopay

$1.5billioninclaimsarisingfromthe2001terroristattacksontheWorldTrade

Centerand$3.5billioninclaimsfromHurricaneKatrinaandother

lossesin2005.Indeed,Berkshireprobablybecameapreferredinsurerin

thewakeoftheseincidents.Berkshiremostlikelydidnotloseanything

Date:Jan20,2010

Time:11:52am

inthisevent.MorganStanleyestimatedthatinsurancepremiumincreases

alonewouldcoverthelosses

fromtheWorldTradeCenterattack.2This

isthepowerofliquidity.

Thesereasonsforkeepingliquidassetsalsoapplytotheaverage

investor.First,whatshouldyoudoifthestockmarketgoesdownsubstan-

tiallyandyoufindsome

wonderfulinvestingopportunities?Ofcourse,

youshouldbuystocks.However,youwillmissthisopportunityifyou

arefullyinvestedinthestockmarketanddonothavecashorcashequiv-

alentsreadytoinvest.Second,whatshouldyoudoifyouneedsomecash

foranemergency?Onceagain,itisgoodtohavesomecashonhand

sothatyoudonothavetosellyourinvestmentsatunfavorablepricesto

coverunexpectedcosts.

Berkshire’sInvestmentsinConvertibles

Convertiblebondsand

preferredstocksaresimilartorent-to-ownstores,

whereyoucanrentfurnitureorappliancesandthen,ifyouwant,pur-

chasetheitems.Becauseofconvertibilityintocommonstocks,investing

inconvertiblebondsorpreferredstocksmayworkwonderfullywhen

thestockpricegoesup.Ifthestockpricegoesdown,thecapitaland

interestpaymentisgenerallystillsafe.Putsimply,itislikeeatingyourcakeand,sometimes,havinganotheronelater.

Thebestexamplesofconvertiblepreferredstockinvestmentsby

BerkshireHathawayinclude$600millioninGillette,$700millionin

Salomon,$300millioninChampionInternational,and$358million

inU.S.Airways.Clearly,ifBuffetthadbeenabsolutelyconvincedthat

thecommonstockpriceswouldincreasesubstantially,

hewouldhave

investedincommonstocksratherthaninconvertiblepreferredstocks.

TheinvestmentinGillettehasproducedexcellentreturns,buttheothers

havebeensortofamixedbag.

Aconvertiblepreferredstock

paysadividendataprespecifiedrateinamannersimilartothatofabond.Forexample,theGilletteconvertiblepreferredstockpurchasedbyBerkshirein1989carriedadividend

rateof8.75percent.Oneadvantageofreceivingdividendsinsteadof

interestisthatabouthalfofthedividendsreceivedbyone

corporation

fromanothercorporationarenottaxable.So,itmakessensetoinvestin

Date:Jan20,2010

Time:11:52am

preferredstocksratherthaninbondswhentheissuerisofsufficientlyhighquality.

SoonafterBerkshireinvested$358millionin1989,U.S.Airways

gotintotroubleand,overthenextfiveyears,incurredsignificantlosses.

Finally,in1994,theairlineannouncedthatitwasdeferringthedividendpayment.Basedonthisandotherinformation,Berkshiredecidedthat

thefairvalueoftheinitialinvestmenthaddeclinedby75percent,and

therefore,the$358millioninvestmentwasworthonly$89.5million.

Fortunately,U.S.Air’soperationsimprovedsignificantly,andBerkshire

recovereditsinvestment.

InthecaseofBerkshire’sinvestmentinSalomon,Berkshirecould

eitherhavetakencashpaymentsof$140millionorreceivedcommon

sharesat$38pershare.In1995,Berkshiredecidedtotakethe$140

millionincashbecausetheSolomonsharepricewasbelow$38per

shareatthetimeofmaturityofpartofthepreferredshareinvestment.

Iftheinitialinvestmenthadbeenmadeincommon

stocks,thedividend

amountwouldhavebeensmaller,andBerkshirewouldhavebeenstuck

withthelower-pricedcommonstock.

BerkshireacquiredpreferredstockinGillettein1989whenBerk-

shirecameinasawhite

knightinresponsetoatakeoverbidbyRonaldO.

Perelman.Suchopportunitiestobeawhiteknightandensuingprofits

availonlytothosewhohaveliquidity.Thepreferredstockwascon-

vertedintocommonstockin1991,andthecommonstockcontinued

toperformwell.Withoutincludingdividends,Gillettegeneratedarate

ofreturnofabout14percentperyearfrom1991untilitwasacquired

byProcter&Gamblein2005,whereastheS&P500indexgeneratedalittleover7percentperyear.

RecentBerkshire

Investments:

Wrigley,GoldmanSachs,GeneralElectric,

SwissRe,andDowChemical

During2008,Berkshireacquired$4.4billionparamountof11.45per-

centsubordinatednotesdue2018ofWrigley.Thisis

straightdebt,but

theratewashighbecauseoftheturmoilinthecreditmarketsatthetime.

Berkshirealsoacquired$2.1billionofpreferredstockwithadividend

Date:Jan20,2010

Time:11:52am

rateof5percentperyearandtheredemptionamountbasedonfuture

Wrigleyearnings.Thus,ifWrigleydoeswell,Berkshirewillshareinthe

upsidewhiletheprincipalisprotected.Buffettcontinuestofollowhis

principlesashesays,“Whenyouthinkofabusinessthat’seasytounder-

stand,withfavorablelong-termeconomics,andableandtrustworthy

management—youthinkofWrigley.”3

Berkshirealsoacquired10percentcumulativepreferredstockof

GoldmanSachsfor$5billionandpreferredstockofGeneralElectricfor

$3billion.Onceagain,thereareconvertiblefeaturesattachedtothese

investments,whichareavailableuntil2013.Inthe

caseofGoldmanSachs,ifthestockpricegoesabove$115pershare,Berkshirewillexerciseits

options—inwhichcase,foreachdollarbeyond$115pershare,Berkshire

willearn$43million.InthecaseofGeneralElectric,foreachdollar

beyond$22.25pershare,

Berkshirewillearn$135million.InMarch

andApril2009,Berkshirealsoinvestedabout$6billioninconvertible

preferredsharesofSwissReandDowChemical.

ThemainlessonwelearnfromrecentBerkshiretransactionsisthat

whenthereissubstantialvolatilityinacompany’sstockorwhenyouare

lessconfidentinthecompany’sfuturegrowth,itmaybeworththinking

aboutformsofinvestmentsinwhichthecapitalispreserved.Youmay

notbeabletodoexactlywhatBuffettdoes,butifyou

haveliquidity,lotsofpatience,andvigilance,opportunitieswillfindtheirwaytoyou.

Conclusions

Donotrushtoinvestinstocksassoonasyouhaveadditionalcashavailableforinvesting.Bepatientandwaitforgoodinvestmentopportunities.

Holdingcashorcashequivalentsisnotjustforsafety;itcanhelpyou

earnmoreonyourinvestmentsbyenablingyoutotakeadvantageof

opportunitiesthatarisewithbriefwindowsinwhichtostrike.From

thisperspective,keepingsomecashorinvestmentsin

liquid,low-risk

securitiesmayprovetobeahigh-returnpropositioninthelongrun.In

somecases,itmightbehelpfultoinvestinconvertiblepreferredstocks

orconvertiblebonds,aslongasyoustaywithestablishedfirmstheway

Buffettdoes.

Date:Jan20,2010

Time:11:52am

Date:Jan18,2010

Time:9:25pm

Chapter16

Diversification:

HowManyBaskets

ShouldYouHold?

Don’tputallyoureggsinonebasket.

—Proverb

Buthowmanybasketsshouldyouhold?Diversificationisoneof

themosttalkedaboutinvestmentconcepts.Theconceptissim-

ple:“Don’tputallyoureggsinonebasket.”Perhapsamore

interestingquestionis,“Howmanybasketsshouldyoupossess,andhow

doyoudecidethenumberofeggstobeplacedindifferent

baskets?”

Weusethebasicsofdiversificationallthetimethroughoutourday-to-

daylives.Whenwetravel,weusuallypackavarietyofclothingsuited

todifferentweatherconditionsbecausewecannotpredicttheweather

perfectly.Welearntospeakdifferentlanguagessowecancommunicate

withotherswhodonotspeakourownlanguage.Weacquireavariety

ofskillstoprepareourselvestoearnaliving.Apersonwithadiverse

knowledgebasefindsiteasiertodealwiththe

unavoidableupsanddowns

oflife.

Date:Jan18,2010

Time:9:25pm

risk,diversificatio

n,andwhentosell

Adiverseknowledgebaseenhancesourunderstandingofothers’

viewpointsandhelpsusmakebetterdecisions.Themoredifferentthings

wehaveinourrepertoires,themorepreparedwearefortheunexpected.

Thus,wediversifytoprotectourselvesfromuncertaintiesandunpleasant

situations.Youshoulddothesametoprotectyourwealth.

Diversification

Consideracompanythatownstwostores,onethatsellsexpensiveclothes

andonethatsellsdiscounted

merchandise.Profitmarginsareusually

higherforexpensiveclothes.Whentheeconomyisdoingwell,the

expensiveclothingstorewillyieldhigherprofits,notonlybecauseof

profitmarginsbutalsobecauseofsalesvolume.However,whenthe

economyisinarecession,theupscaleclothingstoremaybecomea

burden.Butrememberthatthecompanyalsoownsthediscountstore,

whichdoeswellinarecession.Theprofitsfromthediscountstoreact

asacushionduringtherecession.Without

diversification,thecompany

canincurenoughlargelossestocausepermanentdamagetothebusiness.

Investinginstocksisinvestinginbusinesses.Ifyouownedsharesof

Abercrombie&Fitchstock,yourfortuneswouldbetiedtothesuccessesofthatstore’sfashionablegoods.

However,ifyoualsoownedWal-Mart

stock,youwouldbesomewhatprotectedfromtheidiosyncratichabits

ofthehigh-fashionteenagerswhoshopatAbercrombie&Fitch.Own-

ingmorethanonestockisthefirststeptowarddiversification.Beyond

holdingAbercrombie&FitchandWal-Mart,ifyoualsoownedIntelor

IBM,youwouldbeevenmorediversified.

Thebasicgoalofdiversificationistoprotectyourinvestmentsfrom

unpredictableevents.Diversificationisaninsurancepolicy.Whenyou

donotdiversifyandputallyourfundsintothestocksofoneortwo

outstandingcompanies,youcaneasilyenduplosingalotofmoneyif

onecompanyfacesunforeseendifficulties.Ifyoudiversifybyinvestingin10outstandingcompanies,youarelikelytoseegoodresultsevenifafewofthose

companiesdonotdowell.Ontheotherhand,ifyoudiversifya

lot,youmayendupwithapproximatelythesamereturnsasthemarket.

So,howmanystocksshouldyouinvestin?Beforewecananswerthis

question,let’sexaminewhatBuffetthasdoneatBerkshire

Hathaway.

Date:Jan18,2010

Time:9:25pm

Diversification:HowManyBasketsShouldYouHold?

HowDiversifiedIs

BerkshireHathaway?

Attheendof2008,outofBerkshire’stotalassetsof$267billion,

$55billionwasinvestedincommonstocksofvariouscompanies.The

largestinvestment—$9.1billion—wasinCoca-Cola.Otherlargeequity

investmentsincludedWellFargo($9billion),Procter&Gamble($5.8billion),ConocoPhillips($4.4billion),andAmericanExpress($2.8billion).

Berkshire’sequityinvestmentsareconcentratedinonlyafewcompanies.

Weshouldthinkofdiversificationonatleasttwolevels—atthelevel

ofthecompany’stotalassetsandthenatlowerlevelssuchasthecompany’sequityportfolio.OutofBerkshire’stotalassetsof$267billion,only$55

billionor21percentareinvestedincommonstocks.Thisimpliesthatthecompanycanhaveareasonablyhighlevelofconcentrationinitsequity

holdingsandstillbewelldiversified.Inparticular,thefivelargestholdingsmentionedheremadeupmorethan50percentofBerkshire’sequity

portfoliobutonly11percentofitstotalassets.Theseseeminglyconcen-

tratedequityholdingsareactuallynotveryconcentrated,asBerkshireas

awholeiswelldiversified.

BuffettinvestedheavilyinCoca-Colain1989–1999.Attheendof

1999,themarketvalueoftheCoca-Colainvestmentaloneat$1.7billion

was18percentofBerkshire’stotalassetsof$9.5billion.BuffettinvestedheavilyinCoca-Colabecausehewas

confidentinitsfuture.Tenyears

later,attheendof1999,theCoca-Colainvestmentwasworth$11.7

billion.Berkshiremadeamuchsmallerinvestmentof$244millionin

2008intwoIrishbanks,whichwentdownby89percentwithintheyear.

BuffettinvestedaverylargesuminCoca-Colabutonlyasmallamount

inIrishbanks.Themainlessonisthattheloweryourconfidenceinthe

futureperformanceofastock,thelessyouinvestinthatstock.

HowManyStocksShouldYouHold?

First,ifyouownassetssuchasahouseandbonds,youshouldn’tworry

muchaboutdiversificationinyourequityportfolio.Inmyopinion,

ifyourcommonstockportfolioconsistsoflessthanhalfofyournet

worth,itdoesnotmakemuchsensetoholdmorethan15

stocksinyour

equityportfoliobecauseitisdifficulttostayinformedabouttoomany

Date:Jan18,2010

Time:9:25pm

companiesifyouhaveadayjob.Second,themoreyouknowabout

certainstocksandfeelgoodaboutthem,themoreweightyoushould

givethem.Inotherwords,youcanconcentrateyourholdingsinthe

stocksyouhavethemostreasontobeconfidentabout.

Buffettstudiesalargenumberofcompaniesorstocks,butthereare

only16majorholdingsreportedinthe2008Berkshireannualreport.

Thisisprobablybecauseitissodifficulttofindanyoutstandingbusi-

nesses,muchlessagreatmanyofthem.IfBuffettcannotfindalarge

numberofoutstandingbusinesses,itisunlikelythatanaverageinvestor

couldeither.TheDowJonesIndustrialAverage(DJIA)isbasedon30

stocks,butitsreturns,especiallyovermanyyears,

aregenerallysimilartothoseoftheS&P500index,whichincludes500stocks.Forseveral

decades,academicresearchhasshownthatmostbenefitsofdiversifica-

tionareachievedthroughholding20to30stocksinaportfolio.This

evidencehasbeenwell

knownforafewdecadesandisnowwidely

discussedintextbooks.1Figure16.1showsthatonceyouhave20to30

stocksinyourportfolio,addingmorestocksdoesverylittletoreduce

thevolatilityoftheportfolio.2

BenjaminGrahamhasbeenexplicitonthenumberofstocksthata

defensiveinvestorshouldinvestin.Inoutliningvariousrulesforinvestors,hesays,“Thereshouldbeadequatethoughnotexcessivediversification.

StandardDeviation

ofPortfolioReturns

NumberofStocksinthe

Portfolio

Figure16.1

StandardDeviationofPortfolioReturnswithNumberofStocksin

thePortfolio

Date:Jan18,2010

Time:9:25pm

Thismightmeanaminimumof10differentissuesandaboutamaximum

of30.”3Notehismentionofamaximumaswellasaminimum.Buffett

hasclearlyavoidedexcessivediversification.Similarly,JohnNeff,the

legendarymutualfundmanager,placesheavybetsonstocks.Whenhe

retiredin1995after31yearsatthehelmofthehighlysuccessfulVanguardWindsorFund,hisfourlargestpositionsaccountedfor23percentofthe

portfolio.

PhilipFisherWarnsagainst

TooMuchDiversification

PhilFisher,theacclaimedgrowthinvestor,warnsthattheprinciples

ofdiversificationaresosimpleandwidelyacceptedthatmostinvestors

embracediversificationtothepointofexcess.“Thereisverylittlechanceoftheaverageinvestorbeinginfluencedtopracticeinsufficientdiversification,”hewrites.“Investorshavebeensooversoldondiversification

thatfearofhavingtoomanyeggsinonebaskethascausedthemtoput

fartoolittleintocompaniestheythoroughlyknowandfartoomuchin

othersaboutwhichtheyknownothingatall.Itneverseemstooccurto

them,muchlesstotheiradvisors,thatbuyingacompanywithouthav-

ingsufficientknowledgeofitmaybeevenmoredangerous

thanhaving

inadequatediversification.”4

Onereasonthatdiversificationmaynotbeasimportantasitinitially

seemsisthatmanycompaniesarealreadydiversifiedinternally.General

Electrichas12large

divisionsthatareentirelydifferentbusinessesrangingfromaircraftenginestorefrigerators.Thus,ifyouownGeneralElectric

stock,itisalmostlikeowning12differentstocks.Essentially,youneedtoholdonlyafewlargestocks(suchasMicrosoft,IBM,andWal-Mart)

tobecomewelldiversified.

Sometimes,experiencedinvestorsrecommendinternationaldiver-

sification.Thisrecommendationshouldnotbeoveremphasizedbecause

manyU.S.companies,includingCoca-ColaandMcDonald’s,earna

largepercentageoftheirincomefromtheir

internationaloperations.

Also,itmaybemoreadvantageoustoinvestinglobalU.S.companies

thantoinvestincompaniesoutsidetheUnitedStates.Becausemany

countrieshavelessstringentregulationstoprotectshareholders,theydoE1C16

Date:Jan18,2010

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notofferthesameprotectionasU.S.companiesdo,creatingariskier

investmentportfoliothat

woulddefeatthepurposeofdiversifyingin

thefirstplace.Furthermore,byinvestingincompaniesindeveloped

economies,shareholdersaremorelikelytobepartneringwithawell-

educated,well-trained,superiormanagementteamthaniftheyinvested

incompaniesinthedevelopingworld.Beforeyouinvestincompanies

abroad,youshouldfamiliarizeyourselfwiththecountryanditsfinancialregulations,andnotjustthecompaniesthemselves.

Diversificationand“Diworsification”

“IftheonebasketIowned

wasWal-Martstock,I’dhavebeendelighted

toputallmyeggsintoit,”arguesPeterLynch,whousuallyhadhundreds

ofstocksinhisMagellanFund.5Howdoyoureconcilehisargument

thatyoushouldownalimitednumberofstockswithhisdocumented

practiceofowningalargenumberofstocks?Thebestanswerisprovided

byLynchhimself,whosays,“Inmyview,it’sbesttoownasmanystocks

astherearesituationsinwhich:(a)you’vegotanedge;and(b)you’ve

uncoveredanexcitingprospectthatpassesallthe

testsofresearch.Maybethat’sasinglestock,ormaybeit’sadozenstocks.”6

Inarelatedcontext,Lynchexplainshowsomeprofitablecompa-

niesoftenwastemoneyonfoolishacquisitions.Forexample,General

MillsownedChineserestaurants,Italian

restaurants,steakhouses,ParkerBrotherstoys,Izodshirts,coins,stamps,travelcompanies,EddieBauer

retailoutlets,andFootJoyproducts,manyofwhichitacquiredinthe

1960s.Whileeachacquisitionmayhavebeenjustifiedinsomeway,

GeneralMillscouldnot

manageallthesubsidiarieseffectivelyandsuf-

feredfinancially.Individualsareequallycapableofwastingmoneyon

foolishinvestments.Mostpeopleareunlikelytoinvestefficientlyina

largenumberofstocksfromseveralindustries.Insuchcases,diversificationcan

become“diworsification,”asituationinwhichdiversification

canhurtyourreturns,ratherthanprotectthem.Ofcoursethereare

alwaysexceptions.AsLynchhimselfadmits,“Buffett’sBerkshirehas

boughteverythingfromcandystorestofurniture

storestonewspapers,

withspectacularresults.Thenagain,Buffett’scompanyisdevotedto

acquisitions.”7

Date:Jan18,2010

Time:9:25pm

Conclusions

BystudyingtheteachingsofGrahamandFisher,andtakingintoaccount

analysesinmodernfinancialliteratureandthepracticesofBuffett,wecanconcludethat

aprudentinvestmentstrategyinvolvesinvestingin10to30

stocks.Thelessemphasized,butmoreimportant,pointdemonstratedby

Buffett’spracticesisthatthemoreyouknowaboutcertainstocksthatyouhavedeemeddesirable,themoreofthemyoushouldown.Iholdabout

40percentofmyequity

portfolioinBerkshireHathawaycommonstock.

Date:Jan18,2010

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Date:Jan18,2010

Time:9:28pm

Chapter17

WhentoSell

Ifyouaren’twillingtoownastockfortenyears,don’teventhink

aboutowningitfortenminutes.1

—WarrenBuffett

Atypicalmutualfund

portfolioholdsastockforoneto

twoyears;aturnoverof100percentisnotuncommon.

NotBerkshireHathaway’sportfolio,though.Byexamining

Berkshire’sturnoverofstocksandthestockssold,wecanlearnwhat

Buffettwouldrecommendaboutthelengthoftimeyoushouldholda

stockinyourportfolioandwhenyoushouldsell.

TurnoverofBerkshire’sEquityPortfolio:

WhyBuffettHoldsAlmostForever

Istartedanalyzing

Berkshire’sbuyingandsellingofstocksinabout1994.

Attheendof1994,Berkshire’sinvestmentportfolioof$70billioncon-

sistedof$15.2billionincommonstocks.During1995,Berkshiresold

$1.35billionincommonstocksfromitsportfolio.In

otherwords,it

turnedoverabout9percentofitsportfolio.Purchaseswere$1.46bil-

lion,slightlyinexcessofsales.Berkshire’scommonstockportfoliogrewto$39.8billionin1999,andtheturnoverfrom1994to1999averagedabout10percentperyear.Inrecentyears,Berkshire’sturnoverhas

Date:Jan18,2010

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declinedtoabout5percent,

implyinganaverageholdingperiodofabout

20years.

ThisanalysisdoesnotfullycaptureBuffett’sstrongbeliefinlong-

terminvesting.SincesomeofBerkshire’sinvestmentsareforshort-term

arbitrage,thiscomputationis

conservativeinreportingtheaveragehold-

ingperiod.Nevertheless,10to20yearsisstillaverylongholding

period.Icanonlyimaginehowfewinvestorshavesuchlengthyholding

periods.

PartofthereasonBuffett

holdshisstocksforsuchalongtimemustbe

thatheacquiresaconsiderableamountofknowledgeaboutthecompany

beforeheacquiresstockinthecompany.Long-terminvestmentsbest

servethosewho,likeBuffett,buybecausetheyknowalot

aboutthe

companyandhaveconfidenceinitslong-termprospects.Youcould

divideyourportfoliointopermanent,orcore,holdingsandan“other”

categoryconsistingofstocksyouwouldliketolearnmoreabout.With

timeandfurtherexamination,youeventuallydecidewhethertopurchase

moreofthestocksinthesecondcategoryortoselloffthesharesyouhave,dependingonyourmoreeducatedopinionofthecompanies’potential.

Buffettwrites,“[W]henweownportionsofoutstandingbusinesseswith

outstandingmanagements,ourfavoriteholdingperiodisforever.”2

Whyisitagoodthingtoholdstocksforever?Itisonlypreferable

whenthebusinessisexpectedtogiveasatisfactoryreturnforever.Such

stocks,onaverage,donot

comefromhigh-techorhotindustries.This

maysoundcounterintuitive,butmosthigh-techbusinessesdonotsurvive

foralongtime.Ifyouinvestinhigh-techcompanies,youarelikelyto

losemoreoftenthanwhenyouinvestinlow-tech.Ifyouinvestwith

anintentiontopreserveyourcapital,youshouldnotinvestinhigh-tech

companiesunlessyouareextremelyknowledgeableaboutthecompany.

High-techstocksareextremelyvolatileandfraughtwithrisk.Howabout

returns?

Peopleoftenarguethatbusinessesfromeveryday,low-techindustries

cannotearnhighreturns.Buffetthasrepeatedlyprovedthemwrong.

Businessesperformwelleveniftheyarefromtraditionalindustrieswhen

theyareleadersintheirindustriesandwhentheyare

runbyowner-

orientedmanagers.Ownerorientationisespeciallyimportantinthis

casebecausemanagersmustknowwhennottothrowgoodmoney

afterbad.Theymustmakedifficultdecisions.IfBerkshireHathaway

Date:Jan18,2010

Time:9:28pm

WhentoSell

hadnotbeeninsuchgoodhandsinthe1960s,managementprobably

wouldhavetriedtosurviveinthedyingtextilebusinessratherthan

takingmoneyoutofit.Berkshirepulledoutofthetextilebusiness,whileseveralothercompaniesstayedinandwentbankrupt.In2009,most

peoplewouldagreethatonereasonGeneralMotorsfacessuchtrouble

isthatthemanagementnevermadetherightcallonharddecisions.

IfGeneralMotorshadnotexpandedbybuyingcompaniesaroundthe

worldandstartingnewbrands,itwouldhavegivensatisfactoryreturns

toitsshareholders.Overall,Buffett’sprinciplesof

investingineasy-to-understand(low-tech)companieswithexcellentmanagementandthen

holdingthemforevergohandandhand.Together,theyproducehigh

ratesofreturn.

Ofcourse,Buffettdoesnotholdeverystockforever.Togetabet-

terideaofBuffett’sthoughtsonwhentosell,let’sexaminesomeof

Berkshire’smajorsales.

TwoMainReasonstoSell

BuffetthasperiodicallysoldBerkshire’smajorholdings,including

McDonald’sin1998,Travelersin1998,Disneyin

1999,FreddieMac

in2000,andPetroChinain2007.Thelatestreportedmarketvaluesof

thesestockswere$1.4billion,$1.3billion,$1.5billion,$3.9billion,and$4.0billion,respectively.

Firstandforemost,investorsshouldsellwhentheyconcludethat

theyhavemadeamistake.Sometimes,taxlossescanbebalancedagainst

gainstoreducetheoveralltaxbite.Onemajormistake,whichBuffett

admitted,wasthepurchaseofConocoPhillipsstockfrom2006to2008

for$7.0billion.Bytheendof2008,themarketvalueofthe

$7billion

investmenthaddeclinedto$4.4billion,aslideof33percent,whichwas

inlinewiththedropinthestockmarket.In2009,Berkshiresold16

percentofitsConocoPhillipsholdingsandreportedplanstosellmore

inthenearfuture.Whatremainsamysterytomeisthereasonforthis

purchase.Thesimpleexplanationthathewasbettingthatoilprices

wouldriseisnotconvincingbecauseoilpriceshadalreadygoneup

severalhundredpercentinthepriorfewyears.And

Buffettcouldhave

simplybetonoilinthefuturesmarket.

Date:Jan18,2010

Time:9:28pm

risk,diversificatio

n,andwhentosell

Youshouldsellwhenthestockpriceishighinrelationtoitsintrinsic

value.Inotherwords,youshouldsellwhentherearebetteralternatives,includinginvestinginshort-termsecuritiesorholdingcash.BuffettsoldPetroChinastockinthesecondhalfof2007forabout$4billionafter

itspricehadgoneupeighttimessincethestock’sacquisitionin2002

and2003for$488million.Someinthepressspeculatedthathesold

PetroChinabecausehewascriticizedforinvestinginitinthefirstplace:ItisallegedthatPetroChinasupportedtheSudanesegovernment’sinvolvementingenocide

againstpeopleintheDarfurregion.Buffett,denying

thisspeculation,hassaidthathisdecisionwasbasedonlyonpricecon-

siderations.BothPetroChinaandtheS&P500indexdeclinedbyabout

40percentoverthenext18months.Buffett’stimingonthissalewas

correctfromthepricepointofview.

In1997,Berkshiresoldabout5percentofitsportfoliotoincrease

bondholdingsinrelationtostocks.Buffettwrites,“Someofthesales

wemadeduring1997wereaimedatchangingourbond-stockratio

moderatelyinresponsetotherelativevaluesthatwesawineachmarket,

arealignmentwehavecontinuedin1998.”3In2008,Buffettsoldpartial

holdingsinseveralstocks,includingJohnson&JohnsonandProcter&Gamble.Iestimatethedollaramountofthesesalestobeabout$5billion.

BerkshiresoldthesestockstofundlargepurchasesinbondsandpreferredstockinWrigley,GoldmanSachs,andGeneralElectric.Buffettmust

havethoughtthatthealternativeswerebetter.Becauseofpsychological

reasons,investorssometimesdonotsellwhentheyhavetotakealoss.

Theyshouldthinkaboutthesunk-costfallacyandsell.Overall,ifyou

knowyouhavemadeamistake,oriftherearebetteralternatives,you

shouldsell.

WhyWereMcDonald’sandDisneyStocksSold?

Buffettconfessedthathe

shouldnothavesoldMcDonald’sstock.Justas

withpurchases,itisnotpossibletotimesalesperfectly.Thisisoneadditionalreasontoplanforthelongrunwhenbuyinginthefirstplace.He

wroteinBerkshire’s1998annualreport,“Ineedtomakeaconfession

(ugh):TheportfolioactionsItookin1998actuallydecreasedourgainfortheyear.Inparticular,mydecisiontosellMcDonald’swasaverybigmistake.Overall,youwouldhavebeenbetterofflastyearifIhadregularlyE1C17

Date:Jan18,2010

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WhentoSell

snuckofftothemoviesduringmarkethours.”4HesoldMcDonald’s

soonaftertheDairyQueenacquisition,whichwasannouncedinOcto-

ber1997andconsummatedinJanuary1998.Itis

possiblethathedid

notwanttoholdbothDairyQueenandamajorholdinginMcDonald’s

becausethetwocompetedirectlywithoneanother.Acriticcouldargue

thatBerkshirewastryingtomonopolizethefast-foodmarket.Buffett

wouldliketoavoidthosespeculationstoprotecthisreputation.Simi-

larly,whenBerkshireannounceditsacquisitionofBurlingtonNorthern

SantaFeinNovember2009,hesoldBerkshire’s$900millioninvestment

inUnionPacific(2percentstakeinthecompany)and

thecompany’s

roughly$100millioninvestmentinNorfolkSouthern(1percentstake

inthecompany).Evenifthereisnoimproprietyofanysort,impres-

sionsmatter,and,ifso,whyriskreputationatallbyholdingcompetitors’

shares?BuffettprobablyalsosoldDisneysharesforreasonsofreputation.

BerkshiresoldDisneystockin1999.Therearetwopotentialexpla-

nationsforthisdecision.First,hedidnotseemtolikethemanagementatDisneyatthetime.Until1995,Buffett’slongtimefriendTomMurphy

wasthechairmanoftheboardandCEOofCapitalCities/ABCInc.

However,MurphyretiredwhenDisneyacquiredCapitalCities/ABC.

BerkshirereceivedDisneystockinexchangeforitsholdingsinCapital

Cities/ABC.BuffetthasspokenhighlyofMurphybut

hasneverbeenas

complimentaryofDisney’sfollow-upmanagement.

Second,Disney’sexecutivecompensationhadbeensubjecttounfa-

vorablepublicityonatleasttwocounts.MichaelEisner,Disney’s

chairmanoftheboard,

exercisedstockoptionsataprofitofabout$565

millionin1993,followingaprofitof$202millionin1992.Evenwithout

thestockoptions,Eisnerwasamongthehighest-paidexecutivesinthe

UnitedStates.Furthermore,hehadbeengrantedanadditional10-year

contractthatwouldhavekepthimaschairmanandchiefexecutiveofthe

companythrough2006.Thecompensationissueswerehotlydebatedin

severalDisneyannualshareholders’meetings.

Buffettdoesnotbelieveinextremelyhighcompensation.Hence,it

islikelythathewasunhappywiththecontroversysurroundingEisner’s

compensationpackage.Anothercontroversialissuehadbeenthedepar-

tureofthecompanypresident,MichaelOvitz,whoreceiveda$57

millionseverancepackage.Overall,itisnotacomplete

surprisethat

BuffettdecidedtoseverhisassociationwithDisney.

Date:Jan18,2010

Time:9:28pm

risk,diversificatio

n,andwhentosell

WhyWasFreddieMacStockSold?

InBerkshire’s2000annualreport,BuffettnotedthatnearlyallFreddie

Macshareshadbeensoldduringtheyear.Why?Hedidnotelaborate

then.However,withtime,we

havelearnedsomethingveryinteresting

anduseful.5InOctober2007,Buffetttestifiedforthegovernmentin

itscaseagainstFreddieMac’sformerCEO.Buffettdisclosedthathe

wastroubledinpartbyaFreddieMacinvestmentthathadnothing

todowithitsbusiness.“Ifollowtheolddictum:There’sneverjust

onecockroachinthekitchen,”Buffettsaid.Hemadetwoobservations

inhistestimony.First,whenexecutivesofferearningsprojectionsand

cannotmakethenumbers,theystartmakingup

numbers.Second,when

companiesengageinotheractivitiesthatseemtobemotivatedbyaneed

tomakethenumbers,investorsneedtobecareful.FreddieMacwas

forecastingearningsgrowthinthemid-teens;anditappearsthatBuffett

thoughtthatthecompany,unabletomakethenumbers,wouldengage

innonproductiveactivitiestomakeupthenumbers.Overall,Buffettwas

abletoreadearlywarningsoftroubleatFreddieMac.In2000,Freddie

Mac’sstockpricewasaround$60pershare.Itremained

between$50

and$70persharebetween2001and2006,butin2009,itwastrading

ataround$1pershare.

Conclusions

Buffettsellshisstockholdingsinfrequentlybecausehebuysonlyafterheisconvincedoftheirlong-

termvalue.Onereasontosellisthepriceofthestockinrelationtoalternativesavailable,includingholdingcash.BuffettsoldPetroChinaforthisreason.HesoldtheDisneyholdingbecause

hedidnotseemtohaveasmuchconfidenceinthenewmanagement

ashehadintheoldmanagement.Onceagain,

thisshowsthatquality

ofmanagementisveryimportanttohim.Finally,Ilikethecockroach

theoryofearningsmanipulationormanagementbehaviorthatBuffett

described.Whenyouseeanysignsofimpropermanagementbehavioror

questionablenumbersthatmakeyouuncomfortablewiththecompany,

youshouldsellthestockbecauseifyouarepickingupononeproblem

fromtheoutside,thereislikelymorewrongwiththecompanyonthe

inside.Thereisrarelyjustonecockroachinthekitchen.

E1PART06

Date:Dec10,2009

Time:12:55pm

PartSix

MARKETEFFICIENCY

Buffettdoesn’tthinkyouneedtohaveahighIQtobesuccessfulin

thestockmarket.Marketsarenotalwaysefficient.In

Chapter18,

Idiscusssomeofthelesscommonlycoveredaspectsofthemarket

efficiencyparadigm,andinChapter19,Iextendthediscussiontothe

relatedfieldofarbitrageandhedgefunds.

E1PART06

Date:Dec10,2009

Time:12:55pm

Date:Jan18,2010

Time:9:35pm

Chapter18

HowEfficientIsthe

StockMarket?

Essentially,it[EfficientMarketTheory]saidthatanalyzingstocks

wasuselessbecauseallpublicinformationaboutthemwasappro-

priatelyreflectedintheirstockprices.Inotherwords,themarket

alwayskneweverything.1

—WarrenBuffett

Fewpeopleconsistentlymakemoneybettingonhorseraces.In

financeterms,thehorseracingmarketisefficient.Butisthe

stockmarketefficient?

Somepeoplearguethatthestockmarketisefficientand

thatyou

shouldnotspendanytimetryingtobeatthemarketaverages.Onthe

otherhand,others,includingBuffett,arguethatthemarketisnoteffi-

cient.Itisnotproductivetodebatewhetherthemarketisefficient;theimportantpointistothinkabouttheextentto

whichitisefficient.We

comeacrossmanyquestionsinourliveswhenasimpleyes-or-noanswer

isnotverymeaningful.Whensomeoneasks,“AmIgoingtobeableto

makealivingifIstudyengineering?”or“AmIgoingtogetajobif

Ihaveadegreeinmathematics?”thecorrectanswerisgenerally“Yes,

ofcourse.”However,itismoreimportanttoknowhowgoodaliving

youcanexpecttomakeifyoubecomeanengineerorwhatkindofjob

Date:Jan18,2010

Time:9:35pm

marketefficiency

youcanlandifyougetadegreeinmathematics.Inthesamemanner,a

simpleyesornotothemarketefficiencyquestionisnotworthgetting

agitatedabout.Itismoreimportanttoknowhow,when,why,andto

whatextentthemarketisefficientand,especially,how,when,why,and

towhatextentitisnotefficient.

CanIMakeMoneyintheStockMarket?

Insteadofthinkingaboutmarketefficiency,youshouldask,“CanImake

moneyinthestockmarket?”Makingmoneyinthiscasemeansgener-

atingabove-averagereturns.Myanswertothisall-importantquestion

is“Yes,ofcourse.”IfIthoughtotherwise,Iwouldnotbewritingthis

book,Iwouldnotbeinvestinginindividualstocks,andIwouldnotbe

teachingBuffett’sideas.Butitisalsoimportanttorecognizethatmakingmoneyisnoteffortless.Theremaybebargainsoutthere,butthereisno

freelunch.

Asastartingpoint,considerthesetwosimplequestions.Theyshould

helpyoustartthinkingaboutmakingmoneyinthestockmarketand

whetheryoushouldtrytobeatthemarketorwhetheryouarebetteroff

investingyourmoneyinanindexfund.

1.Domostprofessionalmoneymanagersgenerateabove-average

returnsinthestockmarket?

2.Domostindividualinvestorsgenerateabove-averagereturnsinthestockmarket?

Theanswertobothquestionsisno.Ithaspuzzledmeforalong

timethatmostprofessionalmoneymanagerscan’tbeattheS&P500

index.Amongthosewhocan,fewdoitconsistently.Roughlyspeaking,

thisevidencesupportsmarketefficiency.Youthen

needtoask,“Ifmost

moneymanagerscannotbeattheS&P500index,howcanI?”

Firstofall,sincemostmoneymanagersdonotbeatthemarket

averages,itshouldbeclearthatyoushouldnotlistentomostmoney

managers.WhatdoesitimplyaboutreadingtheWallStreetJournalandBarron’sandwatchingCNBC?YoushouldreadthefinancialpressandwatchTVforfacts,forevents,fornews,foranalysis,butnotforopinions.

Youshouldlistentoonlyaselectfew,suchasWarrenBuffett,John

Date:Jan18,2010

Time:9:35pm

Templeton,andPeterLynch,whohavebuiltapreeminentrecordover

manyyears.Otherwise,you

shouldtuneoutwhenunsolicitedadvice

fromtalkingheadscomesyourway.2

MostAcademicsFavorMarketEfficiency

Mostacademicspromotetheefficientmarkettheoryasthemantrafor

investinginthestockmarket.

Itdoesnotsuggestthatintelligentinvestorscanneverbeatthemarket.Themainreasonacademicshaveinternalized

theefficientmarkettheoryisthatitbuildsonappealingassumptions

ofrationality.Butpeopleareoftenirrational.So,attheveryleast,becarefulintakingacademicadviceto

heart:Useapinchofsalt.Once

again,theresearchfindingsmaybeinterestingtolookat,butyoudo

nothavetoagreewithinterpretationsthatcansometimesbeabitofa

stretch,giventheevidence.Andtheacademicsdonotalwaysagreewith

oneanother;somenewacademicresearchnowcastsdoubtonearlier

evidencethatthestockmarketisefficient.3Inacademia,newideasare

alwayswelcomeanddebatedvigorously.Inawell-knownbook,Profes-

sorsAndrewLoandA.CraigMacKinlayexplainseveral

developments

andarguethatfinancialmarketsarepredictabletosomedegreebutfar

frombeingspecimensofinefficiencyorirrationality.4Ittakesconvincingevidencefromavarietyofresearchfindingsbeforenewideasarewidely

accepted.

Evenifthemarketwereefficient,thereisstillnoharminbuying

individualstocksusingyourownknowledge.Inanefficientmarket,you

cannotlosemoneyevenifyouwantto.Forexample,consideragameinwhichyourfriendtossesafaircoin,andyourandomlycallheadsortails.

Inthisgame,youwillwinhalfthetimeandlosehalfthetimeregardlessofwhatyoucall.Inotherwords,inafairgameofchance,evenifyoutrytoloseyourmoney,youcannotdosoconsistently.Ifthestockmarketis

efficient,youcannot,onaverage,losemoneyevenifyouwantto.You

willincurthecostoftradingintermsofbrokeragecommissions,butas

longasyoudonottradeoften,youwilldoaswellas,orbetterthan,

mostmoneymanagers.Ontheotherhand,ifthemarketisnotefficient,

youcanlearnfromyourtradesandyoumaydevelop

theskillsnecessary

tobeatthemarket.

Date:Jan18,2010

Time:9:35pm

marketefficiency

Otherevidenceinthe

academicliteraturesuggeststhatacademics

stillknowlittleabouttheworkingsofthestockmarket.Forexample,

theyhavenotyetcomeupwithagooddefinitionofriskthatworkswell

inpredictingindividualstockreturns.Oneproblemwithreportedbeta

isthatitisonlyanestimate.TruebetacouldbesubstantiallydifferentfromtheestimatedbetainvariouspublicationssuchasValueLine.Inacademicparlance,thestandarddeviationaroundtheestimatedbetais

verylarge.Forexample,whenthereportedbetais1.0,truebetacould

easilyfallanywherebetween

0.5and1.5.And,thereisgenerallynoway

totellifanerrorhasbeenmade.

Mostevidenceinsupportofmarketefficiencycomesfromresearch

thatfallsintothecategoryofso-calledeventstudies,whicharecarefullydoneandpresentsomefascinating

findings.Theyoftenexamineperformanceofaportfolioofstocksafterselectedevents,suchasannouncementsofearningsandmergers.Manyofthesestudiesconcludethataftersuch

anannouncementismade,itisgenerallytoolateforanaverageinvestor

toinvestinthatstock.Thereinliestherub.These

studiesshouldnotbeinterpretedtoimplythatyoucannotidentifystocksthatarelikelytobegoodlong-terminvestmentsinthefirstplace.

Whydopricesdeviatefromfundamentals?Thishappenswhenan

unusualnumberofbuyersorsellerscometothemarketinashorttime,

creatinganimbalance.Thisisaclassicexampleoftheeffectofsupply

anddemandonprices.Forexample,considerasituationwhenyoucome

acrossmanyhousesforsaleinyourneighborhood.Thiscanhappenby

chancealone,withnolong-termeffectonthehousing

pricesinthe

neighborhood.Priceswillthentemporarilyfallandwillremainlow

untilthenumberofhousesonthemarketrevertsbacktonormal.The

mainpointhereisthattherearefrequentimbalancesindemandand

supplythatcausepricestodeviatefromtheirintrinsicvalues.

Inthestockmarket,demandandsupplyseemtofalloutofbal-

ancefrequently.Ifaninfluentialfinancialanalystadviseshisclientstosellaparticularstock,thesupplyofsellersmayoutpacethesupply

ofbuyers.Pricescanthenfallquicklyandmaygowellbelowwhat

thefundamentalswouldsuggest.Thisexamplecanbegeneralizedto

includetheeffectofanynewsordisclosureoffinancialinformation.

Someinvestorsreacttosuchdisclosuresoptimistically

whileothersreactpessimistically.Whenonegrouportheotherdominatesanyparticular

Date:Jan18,2010

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situation,pricescandeviatefromthefundamentals.5Thiscanalsohap-

penfortheentiremarket.In1987,theso-calledportfolioinsuranceschemepracticedbymutualfundmanagersrequiredthemtosellmoreandmore

stocksaspricesfell.On

October19,1987,aninitialdeclineofafew

percentagepointsinthemarketindexesinthepreviousfewweeksmade

portfoliomanagersselladditionalstocks,leadingthemarkettodecline

by23percentinoneday.Investorswhounderstoodthecircumstances

benefitedfromthebuyingopportunity.Ingeneral,individualstocks,

ratherthanthemarketasawhole,aremorelikelytoaffordgoodinvest-

mentopportunitiesbecauseasmallerdollaramountcanaffecttheirpricesconsiderably.

RecentEvidenceonMarket

Inefficiency

Manyrecentacademicstudieshavebeguntoprovideevidencethateven

withinthesimpleresearchframeworkofeventstudies,themarketmay

notbeefficient.Academicresearchersareatalosstoexplainwhy,afteragoodearningsreport,acompany’s

stockpricecontinuestomove

up—andsimilarly,afterabadearningsreport,whythestockpricecon-

tinuestomovedown.Thisevidenceonmomentuminpriceshasalso

beendocumentedforotherevents,suchasspin-offsandstocksplits.6

Theresultsfromotherstudiesshowthatstocksthathavedonewellin

therecent6to12monthscontinuetodowellduringthefollowing

6to12months.Similarly,theevidencesuggeststhatyoushouldavoid

stocksthathavebeenperformingpoorlyinthe

recent6to12months.7

Evidencealsoshowsthatstocksthatunderperformovera5-yearperiod

dowellinthefollowing5-yearperiodandviceversa.8Afterarigorous

examinationofthedata,ProfessorsLouisChan,NarasimhanJegadeesh,

andJosefLakonishokruleoutthepossibilitythatmarketrisk,size,and

book-to-marketeffectscanexplainmomentuminstockprices.9They

concludethattheresultssuggestamarketthatrespondsonlygradually

tonewinformation.Theseresultsaredisturbingto

marketefficiency

advocatesbutmaygiveyouopportunitiestoearnsuperiorreturnsinthe

stockmarket.

Foracriticalthinker,itiseasytocriticizeanyevidence,includingtheevidenceonmarketinefficiency.SomestudiesfindthatthemarketreactsE1C18

Date:Jan18,2010

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marketefficiency

slowly(underreacts)toearningsandotherannouncements.However,

otherstudiesshowthatthemarketoverreactstosome

othertypesof

announcements.Thisleadstotheconjecturethatresearcherslookfor

patternsinhistoricaldata,andgivenenoughcomputertime,theymay

concludethattherearepatternswheretherearenone.Essentially,we

shouldbeawarethatweusehindsightwhenweconcludesomething

fromourresearchfindings.Often,wecanconcludethingsaboutthe

past:thatthemarketwasundervaluedin1974orovervaluedin1972,

forinstance.Withoutthebenefitofhindsight,canwe

reallytellwhen

themarketisover-orundervalued?Notreally.Puttingitanotherway,

therearealwaysenoughpunditswithbullishandbearishsentiments,and

someoftheminevitablyendupbeingcorrect.Overall,insideacademia,

thereisanongoinglivelyandhealthydebateontheextenttowhichthe

marketsareefficientandhowtomeasurerisk.

WarrenBuffettdoesnotsaythatbeatingthemarketiseasy.Inhis

discourseonmarketefficiency,heconcludes,“Aninvestorcannotobtain

superiorprofitsfromstocksbysimplycommittingtoaspecificinvestmentcategoryorstyle.Hecanearnthemonlybycarefullyevaluatingfactsandcontinuouslyexercisingdiscipline.”10Buffettmakesthreemainpoints

aboutchoosingstocksandtryingtobeatthemarket.

1.Tobeatthemarket,you

mustinvestonlyincompaniesaboutwhichyouarelikelytoknowmorethanmostparticipantsinthemarket.

Itisabasicprincipleofmostgames.Ifyouarenotbetterthan

youropponent,youareprobablynotgoingtowinveryoften.Like

Buffett,youshouldfocusononeormoreindustriesthatappealto

2.Buffetthasproposedthatinvestorsthinkofmakingonlyalim-

itednumberofstockmarketdecisionsintheirlifetime.Oncethey

havemadethosedecisions,theyshouldnotbeallowedtomake

anymoredecisions.Ifyoukeepthisinmind,youareunlikelyto

makemanymistakes.Tocementthisthought,thinkabouttheeffort

youexpendedbeforeyouboughtahouseora

computer,before

youdecidedtoattendaparticularcollegeoracceptajoboffer.

Becausethesedecisionsarenoteasytoreverse,mostpeoplemake

gooddecisions.Ifyouthinkofbuyingastockasasimilarlylong-term

commitment,youwillmakebetterdecisions.

Date:Jan18,2010

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3.Tobeatthemarket,youmustlearntoignoreitsvolatility.Itiscommonforinvestorstobecomeanxiousandsellwhenstockpricesgo

downorbuywhenstockpricesgoup.Butwhenaninvestorbuys

astockforthelongrunafterlearningaboutthecompany,market

volatilitywillhavelessofapsychologicalimpactontheinvestor.

Ignorancemaymakevolatilityyourenemy,butknowledgemakesit

yourfriend.

Conclusions

Overall,thestockmarketcanhelpyoumakemoneyifyou

arewilling

toputinthetimeandefforttodevelopthewinningmind-settolearn

toplaythegamewell.Sincemostpeopledonotputmucheffortintoit,

itisnotsurprisingthatmostofthemdonotbeatthemarketaverages.

Forthesepeople,themarketsareefficient.Forthosewhoarewillingto

dowhatisnecessarytomasterthegame,evenifonlyinsmallcornersof

asingleindustry,itshouldbepossibletobeattheopponent:themarket

averages.

Date:Jan18,2010

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Date:Jan18,2010

Time:9:39pm

Chapter19

Arbitrageand

HedgeFunds

Wewillengageinarbitragefromtimetotime—sometimesona

largescale—butonlywhenweliketheodds.1

—WarrenBuffett

Thefancywordarbitrageisnothingtobeafraidof.Anarbitrageis

nothingmorethanthesimultaneousbuyingandsellingofoneor

moresecuritiesthatareeitheridenticalorsimilartoeachother.

ThinkaboutstockbrokeragefirmssuchasCharlesSchwab.Beyondthe

brokeragefee,brokersoftenmakeasmallprofitfroma

transactionwhen

buyingastockfromoneclientandsellingthesamestocktoanotherclientbecausethebuyingandsellingpricesareslightlydifferent.Essentially,thebrokerplaysalittlegameofarbitragingtheprofitbetweenthebuyerandtheseller.

Anarbitrageisnotrisk-free,

becausethebrokeragefirm,likea

wholesaler,carriesinventory.Someofthedealsthatsuchmiddlemen

orarbitrageursputtogetheraremoresophisticatedthansimplyholding

inventory.Manyhedgefundsspecializeinsimilardeals,andfromtime

totime,Buffetthasalsoengagedinarbitragedeals.Thereisnoreason

foryoutobecompletelyaversetothemifyouunderstandtherisks

involved.

Date:Jan18,2010

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marketefficiency

ArbitrageinMergerDeals

Onecommonformofarbitragethatmanycantakeadvantageofismerg-

ers.ConsiderthemergerbetweenGeneralReandBerkshireHathaway

in1998(discussedinChapter8).Accordingtothedeal,200sharesof

GeneralRewouldbetransferredinto21sharesofBerkshireHathaway,

classB.Iftherewasnouncertaintysurroundingthe

merger,theprice

for200sharesofGeneralReshouldbethesameasthepriceof21shares

ofBerkshireHathaway,classB.Formanymonthswhilethemergerwas

pending,youcouldhavebought200sharesofGeneralReforabout5

percentlessthanthepriceyouwouldhavepaidfor21sharesofBerkshireHathaway,classB.

Consideranotherexample.InDecember1998,Exxonannounced

itsintentiontobuyMobil.ThetermsofthedealcalledforMobilshare-

holderstoreceive1.32015

ExxonsharesforeachMobilshare.Aslateas

May1999,Mobilsharesweretradingataround$105,andExxonshares

weretradingat$84.Itwasabout6percentcheapertobuyMobilshares

thantobuyExxonshares.Thus,thewaytoplaythatarbitragewastobuy

MobilsharesandsimultaneouslysellshorttheExxonshares.Sincethe

mergerwastotakeaboutfourmonthstocomplete,theinvestorwould

haveearnedanannualizedreturnofabout18percent.Thisisabout

twicetheaveragereturnonthestockmarket.

Notallannouncedmergerdealsarecompleted,andwhenadeal

isnotcompleted,thearbitrageurmaylosealargepercentageofthe

investment.Therefore,youshouldnotgamblealargeamountinthese

transactions,andwhenadealseemsrisky,itisbestto

avoidit.Itappearsthatimmediatelyafterafaileddeal,investorslookingforarbitrageopportunitiesbecomemorerisk-averse,andtheexpectedpercentagereturns

fromsuchdealsincrease.Thisissimilartothesituationintheinsuranceindustryinwhichinsurancepremiumstendtogoupafterahurricane

oranaturaldisaster.Notonlyarethearbitrageurslesswillingtoinvesttheirmoneyinsuchdeals,butitalsoappearsthatonlythemore-likelyto-succeedmergersarebroughttothemarket.

So,asavvyinvestorshouldincrease,ratherthandecrease,themoney

devotedtosucharbitrageactivitiessoonafterafailed

merger.Thepro-

posed$3.1billiontakeoverofAmericanBankersInsuranceGroupby

Cendantcollapsedin1998whenitwasdiscoveredthatCendanthad

Date:Jan18,2010

Time:9:39pm

engagedinaccountingirregularitiesandfraudanditsstockpricefell

70percent.Almostimmediatelyafterthisfailure,theexpectedreturns

fromarbitragedealsincreasedsubstantially.Anotherconsiderationisthatwhenanumberoflargemergersaretakingplaceatthesametimeinthe

market,thereisnotenoughmoneytogoaround,andexpectedarbitrage

profitsgoup.

Insomesituations,

companiessuchasBerkshireHathawaycangener-

ategoodreturnsforashorttimeatalowerriskthananaverageinvestorcan.Thus,notonlyisBerkshireabletogenerategoodreturnsonits

investingactivitiesinthestockmarket,butitalsogeneratesanoverallsuperiorreturnpartlybecauseofitsarbitrageactivities.For

example,

whenacompanybidsforanothercompanyandneedsmoneyonshort

notice,Berkshiremaybeabletoprovidecashquicklyinexchangefora

higher-than-normalreturn.

AnExampleofaSuccessful

ArbitrageDealbyBuffett

Thefollowingexampleillustratesthatthebetteryouunderstandthe

financialmarkets,themorelikelyyouaretofindarbitrageopportunities.

HereiswhatWarrenBuffettwroteinthe1988Berkshireannualreport:

Someoffbeatopportunitiesoccasionallyariseinthearbitragefield.

IparticipatedinoneofthesewhenIwas24andworkinginNew

YorkforGraham-NewmanCorp.Rockwood&Co.,aBrooklyn-

basedchocolateproductscompanyoflimited

profitability,hadadopted

LIFOinventoryvaluationin1941whencocoawassellingfor5cents

perpound.In1954atemporaryshortageofcocoacausedtheprice

tosoartoover60cents.ConsequentlyRockwoodwishedtounload

itsvaluableinventory—quickly,beforethepricedropped.Butifcocoa

hadsimplybeensoldoff,thecompanywouldhaveowedtaxofclose

to50%ontheproceeds.

The1954TaxCodecametotherescue.Itcontainedanarcaneprovi-

sionthateliminatedthetaxotherwisedueonLIFOprofitsifinventory

wasdistributedtoshareholdersaspartofaplanreducingthescopeof

acorporation’sbusiness.Rockwooddecidedtoterminateoneofthe

businesses,thesaleofcocoabutter,andsaid13million

poundsofits

Date:Jan18,2010

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marketefficiency

cocoabeaninventorywasattributabletothatactivity.

Accordingly,the

companyofferedtorepurchaseitsstockinexchangeforthecocoa

beansitnolongerneeded,paying80poundsofbeansforeachshare.

ForseveralweeksIbusilyboughtshares,soldbeans,andmadeperiodic

stopsatSchrodderTrusttoexchangestockcertificatesforwarehouse

receipts.Theprofitsweregoodandmyonlyexpensewassubway

tokens.2

Long-TermCapitalManagement:TheStoryof

aHedgeFundand

BerkshireHathaway

ConsiderafamouscasethatexplainswhyBuffettwantedtopurchasea

hedgefundandliquidateit.InSeptember1998,BerkshireHathawaypro-

posedacquiringLong-TermCapitalManagement(LTCM),througha

$4billionlimitedpartnershipcomprisingBerkshireHathaway,Goldman

Sachs,andAmericanInternationalGroup.Manyindividualinvestors

thinkthathedgefundstakelargepositionsbutaresomehowhedged

againstlosingmoneyandproduceconsistentlyhigh

returns.Asthenear

bankruptcyofLTCMhedgefundssuggests,investinginhedgefundsis

notashedgedasyoumaybelieve.Sowhataretheimportantlessonsfor

anindividualinvestor?

TheonedistinguishingfeatureofLTCMwasthe

extentofitslever-

age:about25to1.Thefundreportedlyhad60,000tradesonitsbooks,

includinglongsecuritiespositionsofover$50billionandshortpositionsofanequivalentmagnitude.Thegrossnotionalamounts(totalvalueof

leveragedpositions)ofthe

fund’scontractsonfuturesexchangesexceeded$500billion,swapcontractsmorethan$760billion,andoptionsand

othersover$150billion.

LTCM’ssizeandleverage,aswellasitstradingstrategies,madeitvul-

nerabletotheextraordinaryfinancialmarketconditions

thatemerged

followingRussia’sdevaluationoftherubleanddeclarationofadebt

moratoriuminAugust1998.Russia’sactionssparkedaflighttoqual-

ityinwhichinvestorsavoidedriskandsoughtliquidity.Asaresult,riskspreadsandliquidity

premiumsrosesharplyinmarketsaroundtheworld.

DuringthesinglemonthofAugust,LTCMsufferedlossesof$1.8bil-

lion,bringingthelossofequityfortheyeartomorethan50percent.

Date:Jan18,2010

Time:9:39pm

BySeptember21,LTCM’sliquiditysituationwasbleak,andfurther

unfavorablemarketmovementscouldhavecausedittodefaultinafew

days.3

OnthemorningofSeptember23,Berkshireandpartnersproposed

purchasingLTCM’sportfolio.However,atthesametime,aconsortium

of15firmsthatwerethemselvessignificantlyexposedinadefaultsce-

narioproposedinvestinginLTCM.WhileBerkshire’sproposalwasto

takeover100percentofthefund’sequity,thecounterproposalallowed

thecurrentprincipalsandinvestorstokeep10percentoftheequity.

Berkshire’sproposalwasrejected.Buffett’sinterestin

LTCMwasnotan

isolatedeventconsideringhisongoinginterestinarbitrage.InJuly1998,Berkshirecontributed90percentofthecapital($270million)forthe

WestEndCapitalfund(essentiallyahedgefund)managedbyMark

Byrne.Overall,toaknowledgeableperson,hedge

fundsmayofferrisky

butprofitableopportunities.

ThemainlessonfromtheLTCMepisodeisthatlargeleverageposi-

tionseveninthebiggestoffundscanleadtobankruptcy,becauseevents

suchastheRussiandefaultcannotbeplannedintoany

model.Atthe

timeofitsnearfailure,LTCMwasthemosthighlyleveragedlargehedge

fundreportingtotheCommoditiesFuturesTradingCommission.Its

assetswerenearlyfourtimestheassetsofthenextlargesthedgefund.

TheliquidityproblemsfacedbyLTCMwerecompoundedbythesize

ofitspositions,asitcouldnotunwinditspositionseasily.

How,then,couldBerkshirebenefitfromacquiringLTCM?The

basicpointtorecognizeisthatinsuchvolatile

situations,margincallsrequiretheleveragedpartytoliquidateitsportfolioatunfavorableprices.

Marketsbecomeinefficient.SinceBerkshireundoubtedlyhadenough

liquidity,itwouldnothavehadtoliquidateLTCM’spositionsinahurry.

Inanorderlyliquidationover

alongtime,LTCMwouldhavebeenmuch

moreprofitable.AfirmsuchasBerkshirewithexcellentliquiditywill

probablycomeacrossopportunitieslikethisfromtimetotime.

Thisisalsolikelytobetrueforindividualinvestors.Whenmajor

exogenousshocksinthemarketcreatevolatility,pricesgenerallyfall

temporarilybecauseinvestorspreferlessriskyinvestmentssuchasinvestinginTreasurysecurities.Ifyouhaveinvestedinthestockmarket,you

willsufferpaperlosses,butyouarelesslikelytopanicifyouarenot

highlyleveraged.Ifpossible,youshouldtakeanadditionalpositionin

Date:Jan18,2010

Time:9:39pm

marketefficiency

stocks.WhentheLTCMsagawasinfullswing,equitymarketsalso

declined.Asaninvestor,youcouldhavebenefitedifyouhadinvested

inyourfavoritecompanies.WeknowthatBerkshire’sequityholdingin

AmericanExpresswasincreasedbyabout1million

sharesduringthat

period.

Buffett’sinterestinLTCMmighthavecomefromthefactthatthe

financialmarketsweredownheavilywhentheRussiangovernment

defaultedonitsdebt.AlthoughBerkshire’sbidto

acquiretheassetsof

LTCMwasdenied,Buffett’sconjectureprovedtobecorrect:LTCM

earnedhighreturnsinthemonthsfollowingthecrisis.Thisepisode,

onceagain,showstheimportanceofinvestingwhenothersarefearful.

Furthermore,anyoneinterestedininvestinginpositionsthatareriskyintheshortrunhadbetterhavealargecapitalbaseincasethereissuddendemandforadditionalcapital.

ShouldYouInvestinHedgeFundsor

PrivateEquityFunds?

Itisdifficulttocreate

reliablehedgefundindicesbecausehedgefundsarenotrequiredtoreleasetheirperformancedatapublicly.Severalindices

arefrequentlyreportedinthemedia,themostpopularofwhichis

CSFB/TremontHedgeFundIndexandincludesdatasince1993.If

youeverplantousethem,youshouldknowthattherearetwoseri-

ousproblemswithmosthedgefundindices.First,someoftheindices

backfillthedataasfundsreporttheirhistoricalperformance.Fundshaveincentivestoreportonlyfavorablehistoricaldata.Second,mostanalysessuffer

fromwhatisknownassurvivorshipbias:Returnsofindicesmayincludeonlythecurrentlyexistingfunds,omittingthedatafromfunds

thathavegonebankrupt.BurtonMalkielandAtanuSahaexamineda

reasonablycomprehensivedatabaseofhedgefundreturnsandestimated

theeffectsofthesetwobiases.4Aftercorrectingforbiases,theyfindthathedgefundshavereturnslowerthancommonlysupposed.From1995to

2003,thehedgefunduniverseasawholeearnedannualizedreturnsof

8.82percent,versus12.38percentfortheS&P500.Withadditionalanalysis,

theyconcludethathedgefundsareextremelyrisky,astherangeof

individualhedgefundreturnsarefargreaterthantheyarefortraditionalE1C19

Date:Jan18,2010

Time:9:39pm

assetclasses.ProfessorAndrewLo—oneoftheworld’smostrespected

financialeconomists—comestosimilarconclusions.5Healsopresentsa

detailedanalysisofrisk,returns,andliquidityofhedgefunds.

Privateequityandventurecapitalfundsareusuallyregardedasthe

mostsophisticatedinvestmentvehicles.Thefundsaregenerallyrunby

creative,experienced,andarticulatemanagerswhohaveproventrack

recordsinmanagingmoney.Theyarealsoverysecretive

anddonot

readilysharetheirperformanceresults.Hence,thereislessresearchon

returnsfrominvestinginprivateequityfunds.However,theconclusions

fromthebestavailableresearchsuggestthatoutsideinvestors(thosewhodonotparticipateinmanagement)

donotearnabove-averagereturns.

Basedonvoluntarydatafortheperiodfrom1980to2003providedby

about2,000largeprivateequityinvestors,LudovicPhalippouandOliver

Gottschalgfoundthat,onaverage,net-of-feesannualizedperformance

is3percentbelowthatoftheS&P500index.6AnearlierstudybySteveKaplanandAntoinetteSchoarconcludedthatthereturnsareaboutthe

sameasthoseontheS&P500index.Inaddition,thecross-sectional

variationacrossmanagersishigh.7

Onaverage,thereseemsto

benoadvantageininvestinginhedge

fundsbecausethereturnsarenotlargerthanthemarketindices.Ahighervolatilityofreturnsalsoresultsinabiggerbiteintaxesbecausetaxesarepaidwhenreturnsarehighbutmaynotberecoupedwhenreturnsare

low.Finally,thefeestructureofhedgefundsisnotfriendly

toinvestors.

Inthehedgefundindustry,itiscommontochargeafeeof2percentof

theassetsundermanagementand20percentmoreofthereturnsbeyond

acertainlevel.Ifafundreturnis8percentperyearandtheexpensesareabout2percent,youeffectivelylose

25percentofyourearnings,and

thatdoesnotincludetheadditionalamountyouwouldlosewhenthe

hedgefundsdowell.Thismanagementfeestructurebordersonhighway

robbery.

Conclusions

Thehedgefundindustryismadeupofinvestorswhomanagehighly

leveragedpositionsandgenerallyeitherearnextremelyhighreturnsor

earnpoorreturnsthatoftenleadthemtofacebankruptcy.Itisnottrue

Date:Jan18,2010

Time:9:39pm

marketefficiency

thathedgefundsconsistentlyearnhighreturnsandthatcapitalishedgedfromlargelosses.Highleveragedoeswhatitissupposedtodo:increase

volatility.Whenlossesoccur,theyarefierce,asillustratedbytheLTCM

example.Hedgefundmanagersdowellbecauseofhighfees.Investors

inhedgefundsdonot.Theremaybesomegoodhedgefunds,butitis

closetoimpossibletoidentifythem.Mysuggestion

istoavoidinvesting

inhedgefundsaltogether.

E1PART07

Date:Dec10,2009

Time:1:17pm

PartSeven

PROFITABILITYAND

ACCOUNTING

Buffetthasoftenmentionedthatstudyingaccountingandunder-

standingfinancialstatementsarenecessarytobecomeasuccessful

investor.InChapters20to24,Idiscusssomeideasessentialto

understandingBerkshire’simpressiveprofitabilityandlearningtobecome

abetterinvestor.

E1PART07

Date:Dec10,2009

Time:1:17pm

Date:Jan29,2010

Time:3:29pm

Chapter20

M=Monopoly=Money

Amonopolyexistswhenacompanycontrolstheentiremarketfora

specifiedproductorserviceandwhentherearesignificantbar-

rierstoentryinthatmarket.Wecandebatewhether

Microsoft

orGooglehavemonopoliesintheirrespectivemarkets,butwewillcer-

tainlyagreethattheyhavelargemarketsharesinpersonalcomputer

operatingsystemsandWeb-basedsearch,respectively.Muchhasbeen

writtenaboutmonopoliesandnear-monopolies,butonethingisclear:

Almostallofthemmakegoodmoney.Therehavebeenlargemonop-

oliessuchasStandardOilandMicrosoftandsmallmonopoliessuchas

tollboothsacrossbridges.Inthemindsofinvestors,the

letterMshouldstandnotonlyfor“money”butalsofor“monopoly.”So,startsearching

fornear-monopoliesorcompanieswithwhatBuffettreferstoaswide

moatsaroundthem.

WidentheMoat

Buffetthasoftendiscussed

theideaofamoataroundacompany,which

meansanenduringcompetitiveadvantageforthecompany,orameans

ofprotectiontomaintainthecompany’sprofitabilityforalongtime.He

fullyunderstandsthepowerofearningsuperiorreturnsthroughsuch

businesses.ThisisevidentinamemohewroteshortlyafterSeptember

11,2001,urgingBerkshiremanagerstoremainfocused:“Whatshould

Date:Jan29,2010

Time:3:29pm

profitabilityandaccounting

youbedoingrunningyourbusinesses?Justwhatyoualwaysdo:Widen

themoat,buildenduringcompetitiveadvantage.”1

Youdon’thavetoidentifyandinvestinamonopolyinitsearlystages

ofdevelopment.Forexample,Microsoftwentpublicin1986.Youcould

havewaitedfiveyearsandboughtMicrosoftsharesin1991,oryoucould

havewaitedanotherfiveyearsandboughtin1996.

Onlyifyouhad

waiteduntilabout1999—whenMicrosoftstockwasalreadyovervalued,

thecompanywasbeingscrutinizedbythegovernment,andgrowthwas

slowing—wouldyouhavebeentoolatetothegametomakemoney.

ProfitabilityofMonopolies

Monopoliesmakeabove-averagereturns—whichappealstocommon

senseandcaneasilybesupportedbydata.Thereisnobettercontempo-

raryexampleofanear-monopolythanthatofMicrosoft.Microsofthas

considerablepowertosetthepricesitchargesforseveralofitsproducts.

Thenumberofpeoplebuyingacomputerisnotlikelytochangemuch

whetherMicrosoftcharges$199or$299fortheoperatingsystemthat

mustresideinsidemostpersonalcomputers.Most

buyers,whethernew

orrepeat,prefertheMicrosoftoperatingsystembecausesomanycon-

sumersalreadyhaveacompatiblesystem.Thesameistrueforsomeof

Microsoft’sotherproducts.

HowprofitableisMicrosoft?Onewaytojudgeisto

compare

Microsoft’sprofitabilitywiththatofanotherlargecomputercompany.

Forillustrationpurposes,IBMisareasonablebenchmark.AlthoughIBM

hasastakeinboththesoftwareandhardwaresegmentsofthecomputer

industry,theprofitabilityofitssalesrevenueandthatofassetsemployedcanstillbecomparedbecausebothcompaniesareinanindustrythat

requiressignificantresearchanddevelopment.

Table20.1presentsthefinancialhighlightsforMicrosoftandIBM.

Thebasicmetricforcomparingthetwocompaniesisoperatingincome

asapercentageofrevenuesorasapercentageoftotalassets.Overthepastsixyearsforwhichdataareavailable,Microsoft’soperatingincomeasa

proportionofrevenues,oroperatingmargin,on

average,was34percent.

Incomparison,IBM’soperatingmargininthesameperiodwasonly

14percent.Comparingoperatingincometototalassetsratioacrossthe

Date:Jan29,2010

Time:3:29pm

M=Monopoly=Money

Table20.1

ProfitabilityComparisonsofIBMandMicrosoft

FinancialHighlights—IBM

Revenues

$103.6

Totalassets

$120.4

$109.5

$103.2

$105.8

$111.0

$106.0

Operatingincome

asapercentage

ofrevenues

Operatingincome

asapercentage

oftotalassets

FinancialHighlights—

Microsoft

Revenues

Totalassets

Operatingincome

asapercentage

ofrevenues

Operatingincome

asapercentage

oftotalassets

Dollaramountsinbillions.

twocompaniesalsosuggeststhatMicrosoft(21percentoversixyears)is

muchmoreprofitablethanIBM(12percentoversixyears).2

Wheneveracompanycreatesanear-monopolyoran

enduringcom-

petitiveadvantage,itoffersagoodinvestmentopportunity.Inmany

situations,itmaynotbepossibletoinvestinthosecompaniesbecause

theyarenottradedpublicly.Forexample,DeBeersisconsidereda

Date:Jan29,2010

Time:3:29pm

monopolyindiamondmininganddistribution,especiallyinthehigh-

qualitydiamondmarket.However,youcannotinvestinDeBeers

becauseitisaprivatelyheldcompany.

Amonopolystillneedstobemanagedwelltoprotectitsprofitabil-

ity.Becauseoftheirhighprofitability,monopoliesattractcompetition,

andunlessthemonopolistcanmaintainitsmonopoly,profitabilitywill

declineovertime.Inthedrugindustry,acompanymayhaveamonopoly

onadrugforaparticulardisease.Wheneveradrugisahugesuccess,

otherdrugcompaniesstartresearchinginthesamearea

todiscovera

similarchemicalthatisequallyormoreeffectiveintreatingthedisease.

Drugpricesremainhighaslongasthecompanyhasamonopolyover

theproductbutdeclinewhencompetitionemerges.Conversely,con-

sidertheexample(discussednext)ofaBerkshire-ownednewspaperthat

wentfromlosingmoneyinacompetitiveenvironmenttobecoming

highlyprofitablewhenthemajorcompetitorfolded.However,monop-

oliesdonotlastforever.Forexample,unlessnewspapers

reactefficientlytoInternet-basednewsandadvertising,theyarelikelytofaceadecline

intheirprofitabilityandmayevenbecomeextinct.

BuffaloNews:HowProfitabilityChangedDramatically

BerkshireHathawayownstheBuffaloNews,adaily

newspaperinBuffalo,NewYork,acityknownforitsblue-collarworkersandtraditional

industries.WhenBerkshireboughtitfor$32.5millioninearly1977,

theBuffaloNewswasadistantsecondtothelocalCourier-Expressandwaslosingmoney.3ButsinceOctober1982,ithasbeenthe

onlydailymajor

newspaperservingtheBuffaloarea.Themonopolycameaboutbecause

ofeventsthatincludedalonglegalbattleemanatingfromactionbythe

Courier-Express.Inearly1982,CharlieMungerwrote,“Ifthelitigationcontinuesandifthecompetingpaper

succeedsinsomehowchanging

thelawasenunciatedbytheFederalCourtofAppealsandinobtain-

ingthekindsofinjunctionsitisseeking,orifanyextendedstrikeshutsdowntheBuffaloNews,itwillprobablybeforcedtoceaseoperationsandliquidate.”4However,theBuffaloNewspersevered,

anditsvictorywasindeedsweet.In1983,thefirstfullyearafterthecompetitorclosed,the$19millionthecompanyearnedinoperatingprofitscoveredthelosses

fromthepreviousyearswithsomeprofitleftover.

Date:Jan29,2010

Time:3:29pm

M=Monopoly=Money

Figure20.1illustratestheadvantageofamonopolisticenvironment.

Usingtheavailabledatafrom1979to1999,Ireporttheprofitability

(operatingprofitsasapercentageoftotalsales)oftheBuffaloNewsinrelationtotheprofitabilityofallothernon-insuranceBerkshiresubsidiaries,includingSee’sCandies,NebraskaFurnitureMart,andBorsheim’s.The

BuffaloNews’sprofitsjumpedsignificantlyin1983whenitbecametheonlynewspaperintown—whenit

becameclosetoamonopoly.

Inthesubsequentfiveyears,profitsmorethandoubledto$41.8million.

In1999,theBuffaloNewsearnedmorethan$55milliononrevenuesof$160million.Ingeneral,ifyoufindacompanythatislikelytoincreaseitsmonopolisticstance—orwidenitsmoat—growthinprofitswillfollow,

andyouwillprobablyearnahighreturnonyourinitialinvestment.

DominanceDoesNotMeanHighProfits

Whenyoulookforamonopoly,becarefultoinvestigatewhetherthe

companyislikelytoremainprofitablefortheforeseeablefuture.Alargeoreven

dominantcompanyisnotalwaysamonopolyornear-monopoly.

GeneralMotors(GM)hasbeentheworld’slargestcarmanufacturerand

currentlyhasannualrevenuesofabout$200billion,yetitgenerates

almostnoearningsforitsshareholdersandwent

bankruptin2009.It

hasnotbeenearningmonopolisticprofitsforatleast20years.GM’s

declineillustratestheinevitable:Monopoliesdonotlastforever.Their

allurefromaninvestmentpointofviewdiminishesascompetitionsets

inorgrowthpotentialdiminishes.Microsofthadlostitsappealasan

investmentby1999onceitwasnolongerabletoexpanditsbusinessand

profitseasily.IBM,oncethelargestcomputercompanyintheworld,

wasessentiallyamonopolyfromthe1950stothe1970s,

butitappears

tobeanaveragecompanyatbesttoday.

FacingstiffcompetitionfromtheInternet,theNewYorkTimesandmanyothernewspapersin2009remaindominantandmonopolisticso

farasnewspapercirculationisconcernedintheirregion,

butmostof

themarenolongerprofitable.Theirstockpriceshavegonedownwith

theirdecliningprofitability.Inaspanofsevenyearsstartingin2002,thestockpricesoftheNewYorkTimesCompanyandGannett(publisher

ofUSAToday)havedeclined

byabout90percent.TheWashingtonPostE1C20

Date:Jan29,2010

Time:3:29pm

BuffaloNews

Berkshire’sallother

non-insurancebusinesses

ofitabilityPr

–10%

OperatingProfit

Date:Jan29,2010

Time:3:29pm

M=Monopoly=Money

hasalsosuffered,anditsstockpricetradesatabouthalfofitspeakpriceofafewyearsback.Somenewspapers

willtransformintoprofitable

businessesbyshrinkinginsizeorinvestingjudiciously,whileotherswillmakebaddecisionsbythrowinggoodmoneyafterbad.Foraninvestor,

itisatimetowatchandnottoinvestinthesecompanies.

Inmostcases,utilitiesdominatetheirlocalmarkets

andarenear-

monopolies.However,thesecompanies’profitabilityisoftenregulated

becausetheyareconsideredtobenaturalmonopolies;andtheirreturns

toshareholders,whileadequate,arenothigh.Duopolies,ormarketdominationbytwo

companies,aremorefrequentthanmonopolies.Probably,

CokeandPepsi,BoeingandAirbus,andFedExandUPSfallinthis

category.Oftentheyarehighlyprofitable,buttheirstockpricesarealsohigh.Hence,returnstoinvestorsmaynotbehigh.However,ineconomicslowdowns,theirpricesdeclinealongwiththe

restofthemarket.

Then,theyoffergoodopportunitiestobuybecausetheirprofitsalmost

surelyrevertbacktonormalwheneconomiesrecover.

HowtoLookforMonopolies

Thebestwaytoidentifyamonopolyistolookaround.

Generally,smaller

companiesinregionalmarketsaresomewhatmonopolistic.Whilethe

bankingsectorisslowlybecomingcompetitive,someregionalbanks

haveverylittlecompetition.Someresorts,cruiselines,andthemeparks

havelong-established,well-managedmonopoliesintheirregions.Disney

islikelytoearnmonopolisticprofitsinFlorida.CarnivalCruiseLines

alsohaslong-establisheddominancethatmakesitanear-monopoly.You

caninvestigatecompaniesthatoperatetollroads,as

manystateslook

toprivatizetheirtollroads.Monopoliesornear-monopoliesthatareas

large,well-known,ordominantasMicrosoft,Intel,andCiscoarenot

common.Manyotheropportunitiesmaybefoundinlessglamorous

industries,suchasexportersorregionalsuppliersforotherfirms.Everysooften,youmaystumbleuponamonopoly,andwhenyoudo,donot

letitgowithoutathoroughinvestigation.

Simplybecauseafirmappearstobeamonopolydoesnotnecessar-

ilymeanthatitisagoodinvestmentopportunity.Youshouldconfirm

yourinitialimpressionsbyexaminingthecompany’sreturnonassets

Date:Jan29,2010

Time:3:29pm

andonequityand,ofcourse,computeitsintrinsicvalueandmargin

ofsafety.Youshouldtrytoestimatethesustainabilityofitsprofitabilityforanumberofyearsinthefuture.Somesportsfranchises,suchasthe

BostonCelticsbasketballteam,usedtobepubliclytraded.Theremaybe

others.Sportsfranchisesoftenappeartobemonopoliesintheirmarkets,

althoughitisnotobviousthatprofitabilityissustainableinthesamewaythatMicrosoft’sprofitabilityissustainable.Sportsfansdon’thavetogotothe

games.Whenthemarketpunishestheteam’ssharepricebecause

opponentsarepunishingtheteam,youmightstartthinkingofbuying

somesharesinthecompanyifyouthinkthattheteamwillrecover.

Beyondprofitability,thepriceyoupayisevenmore

important.The

stockofamonopoly,suchasMicrosoft,Intel,orCisco,generallytrades

atahighP/Eratio.EvenatahighP/Eratio,sharesofamonopolyare

usuallynotexpensiveforalong-terminvestor.Althoughnodefinitive

ruleexistsforchoosingacutoffP/E,Ihavedevelopedaworkingruleafter30yearsofwatchingthemarket.IftheP/Emultipleisabout200percent

oftheaveragemultiplefortheS&P500,Iwaitforadeclineinthestockprice.Inabsoluteterms,aP/Emultipleof35ishighforme,evenfor

afirmthatseemstobewideningitsmoatorisanear-monopoly.Stock

pricesdeclineperiodicallyforavarietyofreasons,includingnotmeetinganalysts’salesorearningsexpectations,bearishreportsonanindustry,orfearsofinterestratehikesorarecession.Foralong-terminvestor,thesepricedeclines,suchasthoseinearly2009,

signalgoodopportunitiesforinvesting.

DoNotSellaMonopolyinaHurry

IhavemetmanypeoplewhoboughtMicrosoftstockwhenitwasayoung

companyoritspricehaddippedforonereasonoranother.However,

theywerequicktotakeprofitswhenthestockpricewentup50percent

to100percentevenwhentherewasnocompetitoronthehorizon.More

oftenthannot,itisamistaketosellyoursharesinanear-monopolyor

evenagrowingcompanyonceyouhavebecome

knowledgeableabout

thecompanyanditsproducts.PeterLynchsharedhisexperienceswith

owningPhilipMorrisandSubarustock,explainingthatifthegrowth

storyisstillgood,oneshouldnotsell.5Whenyouthinkthatthereisa

Date:Jan29,2010

Time:3:29pm

M=Monopoly=Money

highprobabilityofacompetitor’ssuccess,youshouldsell.Thestockmayappearexpensivefromtime

totime,anditmaynotbeagoodtimeto

addmoresharestoyourportfolio.Butsellingisoftenamistakebecause

thepricemaynotcomedownforawhileforyoutobuyitagain,andby

thetimeitdoes,youmighthavelostinterestinthestockornolonger

havethefundstoreinvestinit.

Periodically,stockpricesofamonopolyoranear-monopolycom-

panygoupsubstantially.Ifthepricedoesbecomeexcessive—say,a

price-to-earnings(P/E)ratioof50—doesitmakesensetosellthe

stock?Themaintoolinyourarsenal,onceagain,isyourestimateof

thecompany’sintrinsicvalue.TheP/Eratioisjustashortcuttocom-

putingintrinsicvalue.Youshouldalwayscomputeastock’sintrinsic

valuebeforemakingadecision.Usually,there

comesatimewhena

company’smonopolisticedgeerodes,whichshouldshowupinyour

estimatedintrinsicvalue.Ifyoufindyourselfinthatsituation,youshouldsellyourshares.Inrecentyears,IsoldmysharesinWashingtonPostandWholeFoodswhentheP/EwasveryhighorIsawthatthe

profitability

wasdeclining.Inboththesecases,itappearedthatcompanydominance

wasslipping.Itbecametoodifficulttopredictthefuture,indicatingthatitwastimetosell.

Conclusions

StandardOilwasamonopoly

intheearlypartofthetwentiethcen-

tury.Currently,Microsoftseemstobeanear-monopoly,althoughit

islosingmarketshare.Foralongtime,allthesecompaniesrewarded

theirshareholderswelluntil,ultimatelyandinevitably,competitionset

in.Althoughlargeandpowerfulmonopoliesarenoteasytofind,many

well-runcompanieswithenduringcompetitiveadvantagesareexcellent

long-runinvestmentsiftheirstockpricesarenotexcessive.Amongthe

stocksownedbyBerkshire,suchcompaniesinclude

AmericanExpress,

Procter&Gamble,Wal-Mart,Coca-Cola,andWellsFargo.

Date:Jan29,2010

Time:3:29pm

Date:Jan18,2010

Time:10:23pm

Chapter21

WhoWinsinHighly

CompetitiveIndustries?

[W]ebelievethat[GEICO’s]costofnewbusiness,thoughdefi-

nitelyrising,iswellbelowthatoftheindustry.Ofevengreater

importance,ouroperatingcostsforrenewalbusinessarethelow-

estamongbroad-basednationalautoinsurers.Bothofthese

competitiveadvantagesaresustainable.Othersmaycopy

model,buttheywillbeunabletoreplicateoureconomies.1

—WarrenBuffett

Insuranceisahighlycompetitiveindustry,butGEICOisfarmore

profitablethanitscompetitors.Retailingisalsoconsideredhighly

competitive,butWal-Martismoreprofitablethanothers.What

characteristicsarehelpfulforacompanytoremainaleaderinanindustrythatmaybeclassifiedasacommoditybusinessorahighlycompetitive

business?Let’strytofindsomeanswersbylookingatGEICO,Wal-Mart,

andothercutthroatcommoditybusinesses.

InsuranceIsaCommodityBusinessLikeRetailing

Wal-Martclearlydominatesthediscountretailindustry.Itissofaraheadofitscompetitionthatitisdifficulttotellwhoissecond.Kmartand

Date:Jan18,2010

Time:10:23pm

SearstogetherareunderonecorporateumbrellaknownasSearsHold-

ings,consideredtobeWal-Mart’smaincompetitor.Wal-Mart’sannual

revenuesareabout$400billion,whereasSearsHoldings’annualrev-

enuesareabout$50billion,onlyone-eighthofWal-Mart’s.Butitwas

notalwaysthatway.BothKmartandWal-Martwere

majorretailers

untilWal-Martpulledintotheleadandeventuallywontherace.Before

KmartandWal-Martbecametheindustryleaders,otherdominantretail-

ersincludedJ.C.Penney,Sears,andW.T.Grant.YoumaynotrecallW.T.

Grant,whichwentbankruptin1975becauseitcouldnotcompetewith

Kmarteffectively.ThenKmartwentbankruptin2002becauseitcould

notcompeteeffectivelywithWal-Mart.Clearly,othercompaniesare

nowtryingtotakemarketshareawayfromWal-Mart.

WhileSearsHold-

ingsisnowconsideredtobeWal-Mart’smaincompetitor,Targetand

CostcoalsocompetewithWal-Marteffectivelyinclothingandwholesale

markets,respectively.And,internationally,CarrefourandTescodovery

wellagainstWal-Martinsomecountries.IfyouarewatchingWal-Mart,

youshouldalsowatchitscompetitors.

Inmanyotherindustries,suchasgrainprocessing,goldcoinmint-

ing,high-endretailing,long-distancetelephoneservice,home-building

materials,andcarsandmotorcycles,afewleadersemergeovertimeas

businessesbecomecommoditybusinesses.SimilartoWal-Mart’ssuc-

cessinretailing,thesuccessofMcDonald’sinfast-foodrestaurantsand

GEICO’ssuccessinautoinsurancehavethesame

underlyingreasons.

TwoMainCharacteristicsofaLeader:

LowCostandCustomerSatisfaction

“Wesellforless”and“Satisfactionguaranteed”aretwoofWal-Mart’s

slogansthateffectivelycapturetwoimportant

principles:lowcostand

customersatisfaction.ToansweraquestioninBerkshire’sannualshare-

holdermeetinginApril2000,BuffettessentiallyechoedWal-Mart’s

slogans.HesaidthatGEICO’ssustainableadvantageswerelowoper-

atingcostsandhigh-qualityservice.LikeWal-Mart’s,theMcDonald’s

operatingmodelhasbeenacasestudyinbusinessschoolsforalong

time.Sofar,BurgerKing,Wendy’s,andmanyothershavebeenunable

toreplaceMcDonald’s.Aslongasyouknowthat

McDonald’ssellsforless

Date:Jan18,2010

Time:10:23pm

anditscustomersarehappy,

youarelikelytoearnrespectable,ifnothigh,returnsoveranextendedperiodbyinvestinginMcDonald’s.InNovember2009,BerkshireannouncedtheacquisitionofBurlingtonNorthern

SantaFefor$34billion.Theacquisitionseemstohavebeenmotivated,

atleastinpart,bythefact

thatrailroadsareamorecost-efficientmethodoftransportinggoodsthantruckers.2

Aracefordominancecanlastalongtime,andthereisnounique

pathtosuccess.Intheautomobilesector,thereweremanymanufactur-

ersfordecadesbefore

GeneralMotors,Ford,andChryslerbecamethe

BigThree.Buteveninthe1920sand1930s,itwasprobablynotdiffi-

culttodiscernwhichonewasemergingastheleader:GeneralMotors

wasbecominglargerandlargerbysuccessfullycombiningOldsmobile,

Chevrolet,Cadillac,andothermanufacturers.Inthe1980s,Wal-Mart’s

strategywasdifferent.Wal-Martdidnotemphasizebuyinglocalretailers.

Instead,itbuiltstoresanddrovethecompetitionoutofthemarket.Lestweforget,outstandingmanagersareinvariablytherealjewelersbehind

developingthesejewels.AlfredP.SloanandSamWaltonweretoGeneral

MotorsandWal-Mart,respectively,justasWarrenBuffettistoBerkshire

Hathaway.

GEICO,undertheleadershipofTonyNicely,focusesondirectmar-

ketingtokeepcostslow.Slowlyandsurely,ithasincreaseditspresenceinthemarketbyadvertisingand,ifnecessary,reducinginsurancepremiums.Typically,asacommoditybusinessaddstoitsmarketshare,its

per-capitacosttokeepitssustainableadvantagegoesdown.Consider,

forinstance,advertisingcosts.Afull-pageadvertisementintheNewYorkTimesdoesnotdependonthesizeoftheinsurancecompany.So,thecostpercustomerissmallerforalargercompany.A30-secondTVspot

onaSuperBowlSundaywillbecheaperforWal-Martforeachdollarin

salesthanforKmart.Inaddition,givenitssmallersalesrevenue,Kmart

maynothaveasmuchofabudgetforadvertisingasWal-Mart.Oncea

competitiveadvantageisestablished,itisdifficulttounseattheleader.

However,watchoutforthepotentialofolddominant

playersto

becomedinosaurs.ThemainreasonKmartfailedwasthatitstarted

expandinginunrelatedbusinessessuchasdo-it-yourselfstores(Builders

Square)anddrugstores(PaylessDrugStores).Technologicalchangesalso

affectthecompetitivefield,especiallywhenadominantplayertakesits

competitiveadvantageforgranted.AcaseinpointisIBM,whichwas

Date:Jan18,2010

Time:10:23pm

aleaderinthecomputerindustryforyears.Inthe1980s,whenthe

personalcomputermarketstartedtobloom,IBMtookitforgranted

thatitwouldmaintainits

leadershipposition.Butthatwasnottobe.

ThedevelopmentoftheInternethastakenatollonBarnesand

Noble’sleadershipinthebookindustry.Amazon.comhasemergedas

theleaderinrevenuesfrombooksalesovertheInternet.Withtime,

Amazon.comisincreasingitsdominanceand,hence,itscostadvantage.

ItisalsotakingsomemarketsharefromWal-Mart.Somehow,someday,

Wal-Mart’sdominancewillerode,butIcan’tpredictwhichcompeti-

torwillemergetochallengeWal-Mart.Ifretailingisin

yourcircleof

competence,youmayspotsuchacandidateearlyandinvestinthat

company.

Thesecondimportantingredientforsuccessinthecommoditybusi-

nessiscustomerserviceorcustomersatisfaction.

AmericanExpresswas

notthefirstcreditcardcompany;DinersClubwas.ButAmerican

Expresscamefrombehind,establisheditsnameonthestrengthofits

customerservice,andcapturedmarketshare.Interestingly,VISAthen

camefrombehindand,usingalow-coststrategy,becamethemarket

leader.Atleastfornow,VISA,MasterCard,andAmericanExpressseem

tobesurvivingwellinthismarketbydifferentiatingtheirproducts.ThemainadvantageforAmericanExpressisitsexcellentcustomerservice.

Overall,itearnsaboutonepercentagepointmoreonchargesthanVISA

andMasterCard.Butitisexpensivetoprovidegoodcustomerservice.

Forthisreason,youmaynoticethatcompaniesoftendecidetoservice

onesegmentofthemarketortheother.Increditcards,

AmericanExpress

preferstoservicehigh-endcustomersbychargingahigherannualfee

andahigherfeetobookairlinetickets.

GoodcustomerserviceisoneimportantreasonforBerkshire’ssuc-

cessintraditionalindustries.

BuffettexplainsBerkshire’semphasison

customerservicethroughthefollowingexample:“Ourtwopipelines,

KernRiverandNorthernNatural,werebothacquiredin2002.Afirm

calledMastiorankspipelinesforcustomersatisfaction.Amongthe44

rated,KernRivercamein9thwhenwepurchaseditandNorthern

ranked39th.Therewasworktodo.InMastio’s2009report,KernRiver

ranked1standNatural3rd.CharlieandIcouldn’tbemoreproudofthis

performance.”3Inthe2008AmericanCustomer

SatisfactionIndexsur-

veyconductedbytheUniversityofMichigan,GEICOrankshigherthan

Date:Jan18,2010

Time:10:23pm

itmajorcompetitorsAllstate,Progressive,andStateFarm.Itseemsthat

itisneitherlowcostnorcustomerservicebutacombinationofthetwo

thatresultsinthewinningstrategyforcompaniesinhighlycompetitive

industries.

Justasacompany’scostadvantagegrowswithmarketshare,the

sameistrueofcustomersatisfaction.Asthenumberofretailcustomers

increased,manyWal-Martstoresstartedtoremainopen24hoursaday.

Inmyneighborhood,Wal-Martisopen24hours,whereasKmartisnot.

Longerstorehoursoftenreducecostsandleavecustomersmoresatisfied.

HowDoCompaniesKeepCostsLow?

Companieskeepcostslowinavarietyofways.Wal-Marthaskeptthe

companyheadquartersinthesmalltownofBentonville,Arkansas.Its

executivessharehotelroomsanddonotdineatfancyrestaurantswhile

traveling.Eventhoughthelargestcostforcompaniesisthecostofgoodssold,costadvantageseemstoemanatemorefromindirectoroverhead

costs.Forexample,haveyoueverwonderedwhylunchpricesarea

fractionofdinnerpricesatmanyfancyrestaurants?Restaurantspaya

fixedmonthlyrent,soiftheycanserveextrameals,theircostpermeal

goesdown.Also,evenifthereareplentyofcustomers

availabletonice

restaurantsduringregulardinnerhours,areducedpricecanhelpattract

additionaldinersearlierintheday.Atoneofmyfavoriterestaurants

inNewOrleans,afixed-pricedinnerbefore6:30p.m.isonly$19,

whereasthesamemealafter6:30p.m.coststwiceasmuch.Extend-

inghoursofoperationalsoreducesoverheadcostsandattractsadifferentsetofcustomers—amechanismknownaspricediscrimination,ineconomicterms.Airlinesthatofferreducedpricesonafternoonflightsor

onnonbusinessdaysalsousethisprincipletoboosttheirprofits.

Youmaybesurprisedtoknowthatitisnotthehighgrossmargin

thatisthedrivingforcebehindWal-Mart’sprofitability.GrossmarginsatWal-MartandKmarthavebeensimilarforyears.ButWal-Mart,whose

inventoryturnoverismuchhigherthanKmart’s,isknownformaintain-

ingahighlysophisticatedandtechnologicallyadvancedsystemtokeep

inventorymoving.Thissystemconsiderablyreducesoverheadcostsper

itemsold,whichbringsabouthigherprofitability.

Date:Jan18,2010

Time:10:23pm

Properuseoftechnologycancutoverheadcostssubstantially.Before

thetelephonebecameubiquitous,GEICOcouldnotpossiblyhavesold

insurancepoliciesdirectlytocustomers.Today,manycompaniesexploit

theInternetandothertechnologiestooperatetheirbusinessesindra-

maticallynewways.Asaninvestor,keepyoureyeson

howtechnology

isbeingusedtoimproveacompany’scoststructure.Youdon’tneedto

buythestockofthecompanythatinventsanewtechnology;itmaybe

easiertofindacompanythatusesthattechnologyeffectively.

Thereisatleastoneadditionalexampleofalow-costcompany

amongBerkshire’ssubsidiaries.Afterbuyinganairplane,Buffettmust

haverecognizedthattheplanewassittingidlemostofthetime.Ifa

mechanismcouldbedevelopedtomakegreater

useoftheairplane,

overheadcostscouldbereduced.In1998,BerkshireboughtNetJets,a

companythatsellsandmanagesfractionallyownedairplanes.InNetJets,

Buffettfoundabusinessthatadherestothesamecost-reducingprinci-

plesthatGEICOandWal-MartfolloweventhoughNetJetscaterstothe

rich.Whiletherearedifferencesacrossbusinesses,itishighlylikelythatNetJetswillgrowintimeasGEICOdid.Mostbusinessesfinallyface

fiercecompetition.SurvivorsfollowWal-Mart’sstrategyoflowcostand

customersatisfaction.

Conclusions

ThenexttimeyouvisitWal-Mart,thinkaboutothercompaniesthat

maybesimilar.Theyneednotbeinthesameindustry.Youshouldask,

“WhoislikeWal-Mart?Whosellsforlessthantheir

competitorsand

providescustomersatisfactionlikeWal-Mart?”Forexample,whenthe

airlineindustrywasderegulated,SouthwestAirlines,undertheleadershipofHerbKelleher,emergedasalow-costproviderwithgoodcustomer

service.Ithasrewardedits

shareholdershandsomely.

Date:Jan29,2010

Time:2:26pm

Chapter22

Property,Plant,

andEquipment:

GoodorBad?

WarrenandIhavehatedrailroadsourentirelife.Theyarecapital

intensive....[They]havelongbeenaterriblebusinessandhavebeenlousyforinvestors.1

—CharlieMunger

DespitewhatCharlieMungerclaimed,from2006to2008,

Berkshireacquired70.1millionsharesofaU.S.railroad,

BurlingtonNorthernSantaFe.Itiscurrentlyoneofthelargest

Berkshireholdings,withamarketvalueof$5.3billionattheendof

2008.WiththeNovember3,2009,Berkshire

announcementofaplan

toacquiretheremainingshares,BurlingtonNorthernwillbecomea

whollyownedsubsidiaryin2010.So,haveBuffettandMungerchanged

theiropiniononinvestingincapital-intensivecompanies,oristheremoretoit?EvenbeforetheBurlington

investment,Berkshireofteninvested

incapital-intensivecompanies.BuffetthadinvestedinU.S.Airways,

PetroChina,andPOSCO(aKoreansteelcompany),allofwhichare

relativelycapital-intensive.

Date:Jan29,2010

Time:2:26pm

CapitalIntensity

Let’sexamineBerkshire’s10

largestcommonstockholdingstounder-

standwhetherBuffettpreferslow-capital-intensitycompanies.In

Table22.1,IpresentananalysisofBerkshire’s10largestholdingsto

understandtheirlevelsofcapitalintensity.

Thereareonlythreecompaniesthatcouldeasilybeclassifiedas

highlycapitalintensive,withproperty,plant,andequipment(PPE)asa

shareoftotalassetsabove50percent.ThesethreeareBurlingtonNorth-

ernSantaFe,ConocoPhilips,andTesco.Threeoutofthe

10(American

Express,U.S.Bancorp,andWellsFargo)needalmostnoproperty,plant,

andequipment,andareclearlyontheotherextreme.Itappearsthat

Buffettdoesnotprefertoinvestinhighlycapital-intensivecompanies.

Shouldweconcludethatanaverageinvestorshouldnotinvestorshould

Table22.1

Berkshire’sHoldingsandTheirCapitalIntensities

Berkshire’s

Property,

PPEasa

commonstock

Totalassets

plant,and

percentageof

investments,

(TA)ofthe

equipment

TA(capital

Company

marketvalue∗

company

intensity)

AmericanExpress

$126.1

Burlington

Northern

SantaFe

Coca-Cola

ConocoPhillips

Johnson&

Johnson

Procter&Gamble

Company

U.S.Bancorp

WellsFargo&Co

1309.6

Dollaramountsinbillions.

∗AsofDecember31,2008.

Date:Jan29,2010

Time:2:26pm

investverylittleincommonstocksofhigh-capital-intensitycompanies?

Thequestionmeritsdiscussion.

Becauseoftheirlargeinvestmentsinproperty,plant,andequipment,

high-capital-intensitycompaniesareusuallyslowinrespondingtomar-

ketforcesorchangesintheeconomy.Forexample,itisverydifficultforanautomobilemanufacturertochangeitscurrentproductwhenacompetitor’sproductsetsanewtrendinthemarket.High-capital-intensity

companieshavelowvariablecostsandhighfixedcosts,whichequals

highoperationalrisk.Whentimesaregood,profitsgoupfasterthan

sales.Whentimesarebad,profitsalsogodownfasterthansales.This

cyclicalityisfurtheraccentuatedbyfinancialleverage,whichalsotendstobehighforhigh-capital-intensitycompaniesbecauseitiseasytoborrow

againstproperty,plant,andequipment.

Thecombinationofoperationalandfinancialriskssuggeststhathigh-

capital-intensitycompanieshaveahigherprobabilityoffacingasevere

financialhardshipthatcouldthreatentheirexistence.Inotherwords,

thedownsideriskfrominvestingintheirstocksishigh—andthatisone

goodreasontoavoidinvestinginthem.Ifmarketsviewedriskthisway,

stockreturnsforhigh-capital-intensitycompanieswouldalsobehigh.

Butthisdoesnotappeartobethecase.WecanusetheDow

TransportationIndexasaproxyforhigh-capital-intensitycompanies

becausemostcompaniesintheindexarehighlycapitalintensive.Data

fromDowJoneswithdividendsincludedareavailableonlyfrom1993.

From1993until2008,annualizedreturnsincludingdividendsonthe

DowJonesTransportationIndexare7.1percent(201percentover16

years)versus8.6percent(276percentover16years)fortheDowJones

IndustrialAverage.

Onereasonthathigh-capital-intensitycompaniesdonotdowellin

thelongrunmaybethattheyfaceproblemsinrestructuringthemselves

whenitmaybenecessarytodoso.Consideranairline.Whendemand

fallsandairplanesareonlyhalffull,itisdifficultto

reducethenumberofpilotsandthenumberofairplanes.Ontheotherhand,alow-capital-intensitycompanysuchasAmericanExpresscantrimthenumberof

employeesrathereasily.

Beyondcommonstockinvestments,whichtradeindependently,

Berkshireownsseveral

businessesthatareinhigh-capital-intensityindustries,andtheircommonstocksdonottradeindependently.Theutilities

Date:Jan29,2010

Time:2:26pm

andenergysegmentemploys$41.6billionintotalassets,ofwhich$28.5

billionor69percentisinproperty,plant,andequipment.FlightSafety,

Iscar,andMarmonarealsoinhigh-capital-intensityindustries,inwhich

IestimatethatBerkshirehasinvestedmorethan$10billion.So,Buffett

doesn’tavoidallhigh-capital-intensitybusinesses,andthesebusinesses

seemtohaveincreasedintheBerkshireportfolioovertheyears.

CapitalIntensityandManagementQuality

WhendoBuffettandMungerthinkthatahigh-capital-intensitybusiness

isworthinvestingin?Let’sgobacktoairlinesbecauseBerkshirewasnotverysuccessfulwithitsinvestmentinU.S.Airways.Anequallycapital-intensiveSouthwestAirlines,ontheotherhand,generatedoutstanding

returnstoitsshareholders.WhatisthedifferencebetweenSouthwest

andotherairlines?

ThemaindifferenceisthatanexcellentCEO,HerbKelleher,was

runningSouthwestAirlines.Notonlydidhestartthecompany;healso

maintainedalargepersonalstakeinit.In2009,thecompanyhadamarketvalueofabout$8.0billion,andKelleherownedabout12percentofthe

commonstock,whichhehasownedsincetheairlinewasstartedin1971.

HeranSouthwestasalow-costairlineduringhistenureasCEOand

didnotdiversifyintootherbusinesses.Atage76,Kelleherisstillthe

chairmanoftheboard,althoughhehasrelinquishedhisCEOposition.

Whenitcomestomanagement,ownershipstake,anddedicationtothe

company,KelleherissimilartoWarrenBuffett.

Forahigh-capital-intensitycompanytobesuccessful,thequalityof

itsmanagementisfarmoreimportantthanitisforalow-capital-intensitycompany.Whentimesaretough,managementofhigh-capital-intensity

companiesneedstohangonandnotgiveintochangeforthesakeof

change.Duringrecessionaryperiods,ifahigh-capital-intensitycompany

makesaseriousmistake,itmayfinditselfinfinancialstraitsandmayevenfacebankruptcy.Manyairlineshavegonebankruptovertheyears,and

somehavedonesotwice.SeveralrailroadsandU.S.Steelhavegone

bankrupt,atleastonce.Ingeneral,itiseasyforhigh-capital-intensitycompaniestoinvestlargesumsofmoney,borrowalotfromcreditors,

andcompoundtheirchancesofgettingintotroubleduringdownturns

Date:Jan29,2010

Time:2:26pm

orrecessions.Onesolutiontothisproblemistoholdalargestakeinthecompany,asBerkshireoftendoes.

In1963,justbeforeBuffettinvestedheavilyinBerkshire

Hathaway,

thecompany’scapitalintensitywashigh,withitsnetPPEconstituting

about32.5percentofitstotalassets.2Tenyearslater,bytheendof1973,netPPEwasonly1percentoftotalassets.Indiscussinghismistakes

overtheprior25years,Buffettsaid,“Myfirst

mistake,ofcourse,was

inbuyingcontrolofBerkshire.”3Asthecompanylostmoney,itwas

noteasytoquicklywithdrawtheinvestmentsfromthemill.Plantassets

neededtobeutilizedforseveralmoreyearsbeforethemillcouldbeshutdown.Notonlyistheprocessof

respondingtodecliningdemandslow,

andchangingtechnologytroublesome;suchadjustmentsalsoconsume

preciousmanagerialtime.

Yourtemperamentmayalsoworkagainstyouwhenyouinvestin

ahigh-capital-intensity

company.Profitabilityofhigh-capital-intensity

companiesishighlychangeable,sostockpricesmayperiodicallydrop

significantly.Aninvestormaybecomenervousandsellthestockinthe

high-capital-intensitycompaniesinadownyear,whenitistheabso-

lutelywrongtimetosell.Pessimisminthemarketplacemayactuallybe

agoodtimetobuyifthelong-termprospectsarenotaffected.Con-

sidertheNovember2009Berkshireannouncementoftheacquisition

ofBurlingtonNorthernSantaFe.WhileBerkshire

purchasedtheini-

tial22percentstakeinBurlingtonNorthernat$78pershareduring

2006–2008,thepricehadgoneupto$114persharebyJune2008as

thestockmarketasawholewentup.However,withthemarketcrashof

2008–2009,BurlingtonNorthern’sstockpricecamedownsubstantially,

andBerkshiremadeanoffertobuytheremainingsharesat$100per

sharewhenthestockwastradingat$76pershare.Ifthemarketandthe

BurlingtonNorthernstockpricehadnotcomedown,it

isunlikelythat

Buffettwouldhavemadeanoffertobuytheremainderofthecompany.

Hehasreportedlysaidthat$100persharewasthemaximumhewas

willingtopay.

Youshouldalsoconsiderwhetherthecompanyisinits

growth

period.High-capital-intensitycompaniesareevenmoreprofitablethan

othercompaniesintheirgrowthphasebecausetheoverheadsarespread

overalargeroutput.Thus,theirstockpricesincreaseratherquickly.Youmayrecallthatsteelcompanies,

infrastructurecompanies,andhousing

Date:Jan29,2010

Time:2:26pm

companiesprosperedinafewyearsleadingupto2007,whentheecon-

omywasdoingwell.Theyalsoinvestedheavilyinproperty,plant,and

equipmentbecauseitwaseasyforthemtoraisecapital.Astheeconomy

sloweddownin2008and2009,theywerelikelyto

sufferheavily.

Conclusions

Foranaverageinvestor,itisbesttoavoidinvestinginstocksofhigh-

capital-intensitycompaniesbecausethedownsideriskappearshigh.This

isnottosuggestthatyoushouldpassonagood

opportunityifyou

understandahigh-capital-intensitycompanywell.Itappearsthatfor

suchcompanies,qualityofmanagementisevenmoreimportantthan

forothercompanies.Berkshire’slargerecentinvestmentinBurlington

NorthernwouldallowBerkshireandthecompanymanagementtorun

thecompanymoreefficiently,andthatmaybeoneadditionalreasonthat

Buffettdecidedtoinvestinthecompany.

Date:Jan19,2010

Time:8:40am

Chapter23

KeytoSuccess:

ROEandOtherRatios

Thebestgaugeofthesuccessofanenterpriseisthepercentage

earnedoninvestedcapital.1

—BenjaminGraham,DavidDodd,andSidneyCottle

Youarelikelytoearnagoodreturnonyourstockinthelong

runonlyiftheunderlyingbusinessisearningagoodreturnon

itscapital.Fromtheshareholders’perspective,returnonequity

(ROE)isusuallythebest

yardstick,asitisolatesthereturnsthatbelongtotheshareholdersfromthereturnstotheenterpriseasawhole.

ROE:UnderlyingPerformanceofaBusiness

Buffettoftenmentionsfinancialratioswhendiscussingabusiness’sunderlyingperformance.Themostimportantofthemall—returnonequity

(ROE)—isnetincomedividedbythebookvalueofshareholders’equity.

BecauseCostcoisawell-runbusiness,Iuseitasanexampletoillus-

tratesomeofthenotableaspectsofROEandrelatedissues.Let’slookatCostco’sROEsforthepast12yearsinTable23.1.

Yearafteryear,CostcohasproducedanROEinexcessof10per-

cent,averaging12.9percentoverthemostrecent12years.Havethe

Date:Jan19,2010

Time:8:40am

Table23.1

Costco’sConsistentReturnonEquityandReturnofAssets

Interest

expenseafter

Fiscal

Shareholders’Returnon

adjustingfor

Returnon

income

equity

assets

$2,468

$5,476

10,090

11,620

13,192

15,093

16,514

17,495

19,606

20,682

stockreturnsbeenaboutthesame?Costco’sfiscalyearusuallyendsat

theendofAugust,andearningsdataarepubliclyknownbyNovember

ofthesameyear.Forcomparingthe12-yearROEstostockreturns,

weshouldthereforeusethe12yearsofstockreturnsfromtheendof

November1996untiltheendofNovember2008.Duringthisperiod,

Costco’sstockprice(splitadjusted)wentupfrom$11.60to$51.47,

givingannualizedreturnsof13.2percentwithout

dividends.Withdivi-

dends,theannualizedreturnsareabout13.8percent.Thus,theROEand

stockreturnsareclosetooneanother.Theannualizedgrowthinearn-

ingspersharewassimilarly13.6percent.However,forvariousreasons,

itmaynotbethesameforotherfirmsandevenforCostcoforother

periods.Forexample,returnsareaffectedbyP/Eexpansionorcon-

tractionindependentofROE.Overall,anexaminationofROEover

anextendedperiodoftimeshouldhelpaninvestor

determinetheper-

formanceoftheunderlyingbusinessthatfinallyisreflectedinstock

returns.

Date:Jan19,2010

Time:8:40am

SinceROEiscomputedfromaccountingdata,youshoulduseitas

astartingpointforinferringstockreturns,butbecarefulnottofollowthenumbersblindly.Asyoumayknow,therearefartoomany

caveats

toconsiderwhenyouuseaccountingnumbersincomplexsettings.For

example,whenacompanypurchasesitsownsharesinthemarketor

paysdividends,bookvalueofequityisreducedandtheROEmaytem-

porarilybecomeveryhigh.Ingeneral,youshouldnotrelyonanyone

financialratio.Youshouldstudygrowthinearningspershareoveran

extendedperiodbeyondexaminingthelevelsofROE.Anyfinancial

ratiocanbemeaninglessorleadyoutomisleading

inferencesunder

certaincircumstances.Hereisanexampletoillustratethispoint.

IanalyzedIBM’s2004financialdatain2005anddiscoveredthatthe

averageROEforthesixyearsthatendedin2004was31.5percent.Atfirstglance,thisseemedtobeverygood.

However,IBM’sgrowthinearnings

pershare(EPS)waspitiful.EPSwas$4.25in1999andremainedabout

thesame,exceptforanincreasein2004to$4.93.Onacompounded

basis,theannualgrowthratewasonly2.5percent.IftheROEwas31.5

percent,whydidtheEPSfailtogrow?Wherewerethoseearningsused?

Withalittlemoreanalysisofthefinancialstatements,Idiscoveredthe

mainreason.Thecompanypurchasedsharesatmarketpricesbutissued

themtoemployeesbelowcostascompensation.For

IBM,thenetresult

wasthatshareholders’equitydidnotgrowbecausesomeoftheearnings

wereeffectivelyusedforemployeecompensationandforrepurchases.As

theIBMexampledemonstrates,ifearningsarenotincreasing,youshould

determineiftheshareholdersaregettingdividends,ifthecompanyis

buyingsharesback,orifthefundsarebeingusedinanunproductive

manner.

WhenyouarenotcomfortablewiththecomputedROEandgrowth

inearnings,youmightstillask,“Whatisthevalueofthecompany’s

commonstock?”Thereareusuallynoeasyanswers,butyoushouldbe

abletofindoutwhatisgoingonbyanalyzingthefinancialstatement.

Unlessyouknowtheanswer,avoidinvestinginthat

company.Thisadvice

issimilartoBuffett’sargumentthatinvestorsshouldstayintheircirclesofcompetence.Inthiscase,insteadoffocusingonthecompany’sproducts,

Iamfocusingonthecompany’saccountingoutputsuchasearnings.In

thecaseofIBM,dividends

hadgrownattherateof6percentinrecent

years.Usingthisgrowthrateandadiscountrateof10percent,Ivalued

Date:Jan19,2010

Time:8:40am

IBMat$25pershare,whichseemedridiculousgiventhestockpriceof

$90pershare.Ididnotinvestinthestock.2

ROA:ReturnonAssets

AcompanionratiotoROEisreturnonassets(ROA).The

mainobjec-

tiveincomputingROAistoobtainameasureofperformancethat

isindependentoffinancing.ROApresentsperformanceofalltheassets

employedbythecompany,notjustequity.Thus,thedenominatoristotal

assetsandthenumeratorisearningsbeforeinterestexpenses,adjustedfortaxes.ROAinTable23.1isgivenbynetincomeplusafter-taxinterest

expensedividedbytotalassets.Also,forsimplicity,Iusetheend-of-the-yeardatainbothnumeratoranddenominator.Overallconclusionsare

similarwhetherweusetheaveragesortheend-of-the-yearnumbers.

AcomparisonofROAtoROEtellsustheextenttowhichthe

companymaybeusingimplicitorexplicitleverage.Manyoftheitems

intheliabilitiessectionofthebalancesheetarenon-

interest-bearing,soanexaminationofinterestexpenseorthebalancesheetanalysiswould

nottellyoutheextentoffinancialleverage.Forexample,thereisusuallynoexplicitinterestexpenseforaccountspayableorforfloatininsurancecompanies.ForCostco,theimportantpointtonoteisthatbecauseof

implicituseoflow-costliabilities,theaverageROEof12.9percentis

abouttwicetheaverageROAof6.4percent.ItappearsthatCostco

hasalsobeenabletousenon-interest-bearingliabilitiessuchasaccountspayabletoaccomplishahighROEfromalowROA.

ThisdiscussiononROEandROAshouldmakeyourealizethat

knowledgeofaccountingisyourfriendinunderstandingtheunderly-

ingprofitabilityofthecompany.Theanalysiswouldalsohelpyouassess

thequalityofmanagement.Ifmanagementqualityisgood,

thefinan-

cialstatementsaregenerallyeasiertounderstand.Youshouldviewthe

financialratiostohelpyouassesstheperformanceofthemanagement

ratherthanlifelessassetsandequity.Ultimately,therearepeoplebehindperformancemetrics.Ihavediscussed

onlytwooftheimportantratios,

butthatdoesnotmeanthatthesearethemostimportantratiosforeach

company.Itdependsonthebusinessmodelofthecompanyandwhat

aspectoftheunderlyingperformanceyouwanttobetterunderstand.

Date:Jan19,2010

Time:8:40am

Youshouldthinkaboutfinancialratioscarefullyindecidingwhatratios

touseandhowtointerpretthem.Inparticular,themainpurposeofdig-

gingdeeperintofinancialstatementsistofinallydevelopbetterforecastsoffutureearningsandbetterestimatesofintrinsicvalue.

BuffettandAccounting

Buffettencouragesinvestorstodevelopagoodknowledge

ofaccounting.

InaBerkshireshareholders’annualmeeting,aNewYorkUniversity

MBAstudentaskedBuffettforhisadviceonhowtodevelopBuffett-like

skills.Inhisresponse,Buffettmentionedthatthestudentshouldtakeasmanyaccountingcoursesas

possible.Rememberthatyouareaconsumer

andnotaprepareroffinancialinformation.Actlikeadetectivetrying

tounderstandthecompany’sbusinessfromreadingfinancialstatements.

Buffettreadsalotoffinancialreports;andforhim,perhaps,thatislike

readingdetectivenovels.Asareaderoffinancialstatements,youcould

havefundiscoveringbehind-the-curtainstories.

Accountingnumbersarebasedonalargenumberofestimates,and

hence,theyarenotreallyhardnumbers.Yet,academicresearchshows

thatlong-shortinvestingstrategiescanoftenbedevelopedbyusing

accountingknowledge.3Whenyoustudyfinancialstatements,beaskep-

tic.Buffettwrites,“Managersthinkingaboutaccountingissuesshould

neverforgetoneofAbrahamLincoln’sfavoriteriddles:

‘Howmanylegs

doesadoghaveifyoucallhistailaleg?’Theanswer:‘Four,because

callingatailalegdoesnotmakeitaleg.’Itbehoovesmanagersto

rememberthatAbe’srightevenifanauditoriswillingtocertifythatthetailisaleg.”4Mostaccounting

numbersarereliable,butyoumustremainvigilant.Herearesomeaspectsofaccountingthatyoushouldkeepin

1.Accountantsmakemanyassumptions.Everyreportednumber

isbasedonassumptionsthataredifferentacross

companiesandon

accountingrulesthatchangeovertime.Herearetwoexamples.First,

ifacompanyownsabuilding,itsreporteddepreciationexpenseis

basedonassumptions.Second,expectedfutureexpensessuchas

promisedhealthcarebenefitstoretireesarebasedonassumptions

aboutlifeexpectanciesandfuturecosts.

Date:Jan19,2010

Time:8:40am

2.Mostaccountingnumbersarehistoricalinnature.When

someoneasksyouthevalueofyourhouse,youarelikelytogive

itscurrentmarketvalue.Incontrast,mostaccountingvaluations

ofproperty,plant,andequipmentaremadeattheirdepreciated

amounts.Inthecaseofland,itisneverdepreciated.Assumethata

companysuchasGeneralElectricpurchasedsomelandfor$5mil-

lion100yearsago.Even100yearslater,thereportedvalue

landonfinancialstatementswillbe$5million.

3.Accountantsmayormaynotusemarketpricesforliquid

assets.Thispracticeisconfusingbecausecompanieshaveachoice

inselectingaccounting

methodsdependingonthedeclaredpurpose

andtheamountsofstocksandbondsheldasinvestments.Someassets

andliabilitiesaremarkedtomarketwhileothersarenot.

4.Accountantsaresupposedtobeconservative.Oftentheyare

indeedconservative,butinmanycasestheyareaggressive.Don’t

forgetthatWorldComaccountantsweretooaggressivetoreport

highearnings.Theapproachtheyusedisnotdifficulttodiscern.

From1999to2002,WorldCommisclassified

$8.1billioninexpenses

asassets.5Theamountwassolargethatwhenitwasdetected,the

companywentbankrupt.Soyoushouldnotassumethataccountants

arealwaysconservative.

Buffetthasoftendiscussedaccountingissuesin

Berkshire’sannual

reports.Ingeneral,thebetteryouareataccounting,thebetteryouwillbeatunderstandingfinancialstatementsand,byextension,understanding

andvaluingcompanies.

Conclusions

Ultimately,thereturnon

yourinvestmentsincommonstockswill

dependontheunderlyingreturnonthecapitalusedinthebusiness,

whichcanbemeasuredbyreturnonequityandreturnonassets.Those

returns,whenusedproperly,giverisetogrowthinearningspersharethat

engendersincreasesinthepriceofthestock.Thus,itisimperativethatyoucomputeROE,ROA,andotherfinancialmetricssuchasgrowth

inper-shareearningsandbookvaluetoexaminehowtheunderlying

businessisperforming.

Date:Jan29,2010

Time:2:29pm

Chapter24

AccountingGoodwill:

IsItAnyGood?

Youcanliveafullandrewardinglifewithouteverthinking

about[accounting]Goodwill....But,studentsofinvestment

andmanagementshouldunderstandthenuancesofthesubject.1

—WarrenBuffett

Hereisasurprisingfact:TheaccountingGoodwillamountshown

infinancialstatementshas

almostnothingtodowiththeword

goodwillineverydayuse.However,itisoftenasignificantper-

centageoftotalassetsonacompany’sbalancesheet.TobetterunderstandaccountingGoodwill,IpresentdataonGoodwillandotherassetsfor

severalwell-known

companies.Ialsodiscussitsimplicationsforyouin

evaluatingcompanyprofitability.

AccountingGoodwillandItsEconomicValue

Table24.1reportssummarybalancesheetsalongwiththerecent

Goodwillamountsforseveral

well-knowncompanies.Goodwillasa

proportionoftotalassetsforthesecompaniesisbetween3percentfor

ConocoPhillipsand42percentforProcter&Gamble.Thereisno

Date:Jan29,2010

Time:2:29pm

Gamble

Electr

General

ConocoPhillips

Companies,

Coca-Cola

Assets

Berkshir

billions.

centage

Goodwill

assets

plant,,

assets

amounts

assets

vestments

ventor

operly

equipment,

Goodwill

Dollar

Date:Jan29,2010

Time:2:29pm

apparentassociationbetweenthesepercentagesandtheeverydaymean-

ingofthewordgoodwill.ForMicrosoft,reportedGoodwill

of$12billionisonly17percentofitstotalassets.Bycontrast,Procter&Gamble’sGoodwillof$60billionis42percentofitstotalassets.How,then,shouldyouanalyzethereportedGoodwillinfinancialstatements?

ConsiderBerkshireHathaway’s$34billionofreportedaccounting

Goodwill.Wherediditcomefrom?Thisamountrepresentsthevalue

givenincashorstockbyBerkshireinvariousacquisitionsinexcessof

identifiablenetassets.Forexample,BerkshireacquiredGeneralRein

1998for$22billion,butGeneralRehadonly$7

billionofnetassets.Theadditional$15billionBerkshirepaidisreportedasGoodwill.Similarly,

whenBerkshireacquiredGEICOin1996,Berkshireadded$1.6billion

ofGoodwill.ThetotalamountofGoodwillof$34billionderivesfrom

variousBerkshire

acquisitionsovertheyears.InadditiontoGeneral

ReandGEICO,DairyQueen,ExecutiveJetAviation,andIscarMetal

WorkshavecontributedtoBerkshire’sGoodwill.

Asaninvestor,youwouldliketoknowiftheeconomicvalueof

accountingGoodwillisworthmoreorlessthanthe$34billionfor

Berkshire.First,Berkshiredidpay$34billionincashorstocktoacquireGoodwill.Hence,fromaninvestmentpointofview,reportedGoodwill

issimilartootherassetssuchasproperty,plant,andequipment.The

objectivethenshouldbetoanalyzetheGoodwillandfinancialstatements

totheextentthatthisassethelpsproduceearnings.

GoodwillandEarnings

WhydidBerkshireacquireGEICO,GeneralRe,andIscarwithacquisi-

tionpremiums?Themain

reasonthatapremiumispaidisthepotential

growthinacquiredbusinesses.Buffettexpectedthesecompaniestogrow,

andhepaidpremiums.ConsiderGEICOagain.GEICO’srevenues

increasedfrom$3billionin1996to$12billionin2008,agrowthrate

of12percentperyear.IfthisgrowthrateishigherthanwhatwaspricedinGoodwillatthetimeofacquisition,theeconomicvalueofGoodwill

ishigherthanwhatthefinancialrecordsshow.Wedonotknowwhat

Buffettexpectedthegrowthratetobeatthetimeofacquisition,but

12percentisaverygoodgrowthrategiventhatGEICOisinamature

Date:Jan29,2010

Time:2:29pm

industry.Thus,theeconomicvalueshouldbehigherthanthe$1.6bil-

lionBerkshirepaidfortheaccountingGoodwill.Inthiscase,accounting

Goodwillislikerealestatewhosevaluehasgoneupwithouthavingthat

increasereflectedonthebalancesheet.

OneshouldconsiderwhethertheCEOoftheacquiringcompany

wantedtoincreaseshareholdervalueorhadanotherreasonfortheacqui-

sition.Ifthereappearstobesomeothermotive,suchastheCEO’sego,itmaybebesttoavoidthatcompany’sstock.AtleastthevalueofGoodwill

wouldbemuchlower,andinmanycases,itmaybeassumedtobeclose

tozero.InthecaseofBerkshire’sCEO,theanswerisclear.WeknowalotaboutBuffett’shistoricalrecordintermsofownerorientation,andsinceBuffettandMungereffectivelyownacontrollinginterestinBerkshire,

theyhavenoincentiveto

undertakeamergerforthesakeofincreasing

thecompany’ssizeorsomeotherperversereason.

BuffettdiscussesGoodwillregardinghisacquisitionofSee’sCandies.

“In1983,See’searnedabout$27millionpretaxon$11millionofnet

operatingassets;in1995,itearned$50millionononly$5millionofnetoperatingassets.Clearly,See’seconomicGoodwillhasincreaseddramaticallyduringtheintervalratherthandecreased.”2Asplantassetsareused,theirvaluesoftendeclineowingtodepreciation.Youshouldnotthink

ofGoodwillinthesame

manner.TheinternallygeneratedGoodwillis

notreportedonthebooks.So,howshouldonethinkaboutprofitability

andGoodwill?

GoodwillandProfitabilityofAcquiredBusinesses

Berkshire’sbusinessesfallintothreemaincategories:

insurance;man-

ufacturing,service,andretailingoperations;andfinanceandfinancial

productsbusinesses.Inthissection,Ipresentrecentdatafromthesec-

ondcategorytoshowhowinvestorsmaylookatreportedaccounting

Goodwilltothinkaboutfutureprofitability.

Table24.2givesthebalancesheetofvarioussubsidiariesinBerk-

shire’smanufacturing,service,andretailingbusinesses,whichincludes

MiTek,ShawIndustries,NetJets,McLane,andothercompanies.At

theendof2008,theequityinthisgroupwas$30,779million,and

netincomefortheyearwas$2,283million.Forsimplicity,usingthe

Date:Jan29,2010

Time:2:29pm

Table24.2

Berkshire’sManufacturing,Service,andRetailingOperations

BalanceSheet,12/31/08

Assets

LiabilitiesandEquity

Cashandequivalents

$2,497

Notespayable

$2,212

Accountsandnotes

Othercurrentliabilities

receivable

Inventory

Totalcurrentliabilities

Goodwillandother

Deferredtaxes

intangibles

16,515

Fixedassets

16,338

Termdebtandother

liabilities

Otherassets

Equity

30,779

$49,897

year-enddata,thereturnonequity(ROE)(2,283/30,779)was7.4

percent.

Successfulinvestingisaboutlookingahead.ThinkaboutwhatBerk-

shire’sfutureincrementalrateofreturnmightbe.A

simpleapproachis

toimaginativelyfast-forwardseveralyearswhenBerkshiresubsidiariesinthissectorwillbetwicetheircurrentsizeandearntwicetheircurrent

profits.Inotherwords,considerthesituation,maybein10years,when

netincomewillbedouble,or

$4,566million.Togeneratetheadditional

netincome,totalassetsneednotbetwicetheinitialamountbecause

theGoodwillpartoftotalassetsdoesnothavetobepurchasedagain.

SomefundsmayhavetobespenttomaintaintheGoodwill,butitis

hardtobelievethattheamountneededwouldbetwicetheinitialsum.

Thisisbecauseexpensesforadvertisingorresearchanddevelopment

thatarerequiredtomaintainGoodwillaresubtractedfromrevenuesin

computingnetincome.

Forthisillustration,Imakethereasonableassumptionthatno

additionalamountinGoodwillwillbeneededforgrowth.Ignor-

ingGoodwill,additionalassetsneededare$49,898millionminus

$16,515million,or$33,383million.Iftheliabilities

amountsequal

Date:Jan29,2010

Time:2:29pm

thosein2008($19,118),the

newequityneededwouldbe$14,265

million.Theincrementalreturnonequityof$14,265millionwould

be$2,283/$14,265,or16percent.Thiswouldbeaverygoodreturn

indeed.IfyouhadignoredthespecialaspectofGoodwill,youwould

haveincorrectlyassessedROEtobeonly7.4percentascomputedear-

lier.Irepeatthatinallsuchpredictions,wemakemanyassumptions,andoneshouldalwayskeepthatinmind.Overall,ifacompanyislikelyto

growandhasgoodmanagement,youmaycomputetherateofreturn

withoutreportedGoodwill.Youmaythenuseyourprojectednumbers

tocomputethecompany’sintrinsicvalue.

Conclusions

ReportedGoodwillinfinancialstatementsrelatesonlytoacquisitions

andistheamountpaidabove

thenettangibleassetsacquired.Ifacom-

panyafterbeingacquiredcontinuestogrowinrevenueswiththesame

levelofprofitmargin,thereturnonequitywillalsogrowbecause

noadditionalinvestmentinGoodwillisgenerallyneeded.Account-

ingGoodwillisindeedavaluableassetinwell-managedcompanies.In

computingreturnonequityandintrinsicvalue,youshould,therefore,

payspecialattentiontoGoodwill.

E1PART08

Date:Dec10,2009

Time:3:11pm

PartEight

PSYCHOLOGY

Buffetthasoftenmentionedthatitisdifficulttopredictthemarket

intheshortrunbecausemarketparticipantsarenotallrational.

Youwillbeabetterinvestorifyouareabletodealwith

market’supsanddowns.InChapters25and26,Idiscussimportant

ideasfrompsychologytohelpyoubetterunderstandthemarketsand

yourself.

E1PART08

Date:Dec10,2009

Time:3:11pm

Date:Feb4,2010

Time:2:41pm

Chapter25

HowMuchPsychology

ShouldYouKnow?

Thedumbestreasonintheworldtobuyastockisbecauseit’s

goingup.1

—WarrenBuffett

Manyinvestorsmakedumbdecisionsbychasingstockprices.

Doyou?Ifso,whatcanyou

doaboutit?Wewillgetbetter

answersbystudyingpsychologythanbyboninguponfinance

alone.Thefascinatingfieldofpsychologyisnolongerlimitedtohuman

behaviorinsocialsettings.Inrecentyears,behavioralfinancehasshed

lightonthepsychologyofstockpricesandfinancialdecisionsbymarket

participants.Essentially,twomainforcesaffectstockpricesinthemarket:thefundamentalsofthecompanyandhumanbehavior.Bothforceshave

aroletoplay.However,acombinedknowledgeofthetwoshouldmake

amorepowerfulfoundationformakingintelligentdecisionsinthestock

marketthanrelyingonfundamentalsalone.Sincealongdiscussionof

psychologywilltakeusawayfromourmaingoalof

becomingbetter

investors,onlyissuesthatareimportantfromaninvestingpointofview

willbecoveredhere.

Date:Feb4,2010

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psychology

HerdingandYou

Youdonotneedadegreeinpsychologytounderstandthatintheshort

run,thepriceofastockcandeviatesubstantiallyfromits

basicvalue

becausemarketparticipantsmaybetrayaherdinstinctintheirbehavior.

Thisisprobablythemostimportantconceptthatyouneedtoknow

aboutmarketpsychology.Whenpeopledonotunderstandacompany

well,theyfollowthecrowd:Theychasethewinnersanddumpthelosers

indiscriminately.

Becauseofthisherdmentality,individualstocks—andtheentire

market—maygoupordowndramatically.Herdingstemsfromgreed

orfear.Wheninterestratesriseorwhentherearefearsthatanimpor-

tantcountry’seconomywillfalter,worldmarketsreactsubstantially.It

isextremelydifficulttotimethemarketortoforecasteventsthatmake

marketsmovedramatically.Thelessontolearnisthat

whenthemarket

doesgodownsignificantly,primebuyingopportunitiesmaysurface.

Doyouknowwhetheryouhavetheherdinginstinct?It’sagood

ideatofindthatoutifyoucan.ThemostcommonphenomenonI

haveobservedisthatpeoplefeellikebuyingastockwhenitspricehas

recentlygoneuporwhenthemarkethasgoneup.Ifyoudosowith-

outevaluatingthecompany,youareprobablyherding.Doyouevaluate

thepriceincreaseinalogicalmanner?Youareprobably

notherding

ifyoucomputeastock’sintrinsicvaluebeforeyoumakeabuyorsell

decision.

Investorsoftenextrapolateevidencefromrecenttrendsandthen

decidetobuyorsell.Ifitwereeasytopickstocks

basedonrecentpricetrendsalone,mostmutualfundmanagerswouldbeabletobeatthe

marketindices.Butmostofthemdon’t.Foreverytrendthatcontinues,

thereisprobablyanotheronethatdoesnot.Considertwoleadersinthe

personalcomputerindustry

inthelate1990s:DellandCompaq(now

HewlettPackard).By1998,Dell’sstockpricehadgoneupbyseveral

hundredpercent,atrendthatcontinuedfortwomoreyears.Howabout

Compaq?LikeDell,Compaqhadatremendousrununtil1998,but

in1999,itspricewentdownby50percent.Bothstocksbelongedto

thesameindustryandfacedsimilarmacroeconomicenvironments.If

youhadboughtCompaqinsteadofDell,youwouldhaveregrettedyour

decision.Youweremorelikelytohavechosenthe

betterstockifyouhad

Date:Feb4,2010

Time:2:41pm

triedtoidentifythe

fundamentalreasonsbehindthesuccessesofDellandCompaq.By1998,Compaq,inanuntestedstrategy,waspushinginto

IBM’smainframeterritorybyacquiringDigital.Giventheuncertainty,

ahighpriceforCompaqwasnotjustified.

Investorsherdoftenandin

somecasescreatemarketeuphoria.Inthe

late1990s,everyoneboughthigh-techstocks.Thetech-heavyNASDAQ

indexpeakedat5,048onMarch10,2000.Investorswereherding.One

interestingpointtonoteisthatmanyinvestorswhothoughtthemselves

tobeindependentoftheherdmentalityavoidedhigh-techstocksbut

boughtotherstocks.Duringthisperiod,mostnon-high-techstocksalso

becameexpensive.Forexample,Coca-Colatradedat$80pershareat

aprice-to-earnings(P/E)ratioofabout50.Whatcould

explainthis

highpriceotherthanherding?Itisindeeddifficulttoavoidherding;

eventhosewhothoughttheywerenotherdingwereinfactalsoherding

bybuyingnon-high-techstockssuchasCoca-Cola.Theyallsuffered

laterin2000andinfollowingyears.IfyouboughtBerkshireHathaway

stock—forwhichthepricewentdownduringthesameperiod—you

werenotherding.(IdidbuysomeadditionalBerkshirestock.)Inthe

early-tomid-2000s,peopleboughthomes.Theywere

herding.Many

otherswhothoughtthattheywerenotherdingboughtstocks.Theydid

notknowit,buttheywerealsoherding,asstockpriceswerealsohigh.

Allassetpriceswereinabubble.Mostinvestorssufferedinthedownturnin2008.

Thebestantidotetoherdingliesinknowledgeandinfocusingonthe

longrun.Buffett’ssuggestionofbuyingonlywhatyouknowmayhelp

youavoidfollowingtheherd.Inaddition,concentrateonfundamentals.

PeterLynchhascapturedthisideainthechapter“Earnings,

Earnings,

Earnings”inhisbookOneUponWallStreet.Heexplains,“Whatyou’reaskinghereiswhatmakesacompanyvaluable,andwhyitwillbemore

valuabletomorrowthanitistoday.Therearemanytheories,butto

me,italwayscomesdownto

earningsandassets.Especiallyearnings.”2

ReadingPeterLynchorWarrenBuffettwasagoodstartforme,but

notenough.IunderstoodthembetteronlyafterIdelvedintolearning

behavioralfinanceandevaluatingmydecisions.Andittookmeseveral

yearstounderstandthatIhadaherdmentality.Toavoidherding,Itrytozeroinonthelongterm.FollowPlato’scenturies-oldwisdom:“Know

thyself.”

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psychology

ExamineYourBuyingandSellingPatterns

Howcanyoudeterminehowyoumakedecisions?Myapproachisto

writedownmyreasonsforbuyingandsellingastockimmediatelyafter

Imakeadecision.IfIdon’tdothis,IfindthatI’mnothonestwith

myselflater.Withthebenefitofhindsight,Icanalwaystrytojustifymychoices—whichpreventsmefromunderstandingmyselfandimproving

mydecision-makingabilities.Afterafewyearsofthispractice,Icame

tounderstandmanyofmyhabits.Talkingwithothers,Ihaverealized

thatmanyofmyweaknessesarecommon.IsawthatIwasmuchmore

influencedbypricemovementsthanIthoughtIwas.Igotexcitedto

buywhenamergerwasannounced,whenaproduct

waslaunched,when

thedollar-yenexchangeratechanged,orwhenanineffectiveCEOleft

acompany.

Intheshortrun,whenevermydecisionsprovedtobecorrect,I

foundmyselftalkingaboutthem.Ipaidlessattentionto

myincorrect

decisions(Kmart!).Ialsorealizedthatmylong-runresultswereusually

notrelatedtowhathappenedtothestockpricerightafterIboughtthe

stock.ButIwaspayingmoreattentiontothestockimmediatelyafter

Ihadpurchasedit,whenIshouldhavebeenpayingmoreattentionto

thestockbeforepurchasing.Idothatnow.AlthoughIalwaysbelievedintheimportanceofearningsandassets,Ididnotunderstandtheirfull

significanceinmydecisionmakinguntilIstartedwriting.Ilearnedthe

valueoflookingatalonghistoricalrecordofperformance.

Inadditiontowritingdownyourdecisionsandanalyzingthemlater,

youmaytryothertechniquestolearnmoreaboutyourdecisionmaking.

Forexample,youmayseparateallthemonthsthe

marketwentupfrom

themonthsthemarketwentdown.Fromyourbroker’sstatements,you

canfindoutwhetheryouwereanetbuyeroranetsellerduringvarious

months.Ifyouwereanetbuyerduringthemonthsthestockmarket

declined,youaremorelikelytobeacontrarian.Butifyouwereanet

buyerwhenthestockmarketdidwell,youmayhaveaherdmentality.

Ifyoudelayyourdecisionswhenthemarketisgoingupordown,

youmightwanttoanalyzeyourbuyingandselling

patternsinthemonths

followingtheperiodwhenthemarketmovesupordown.Asimpleanal-

ysislikethiscantellyoualotaboutyourself.Youcouldalsoredesign

thisapproachtosuityourneeds.Forexample,youcanexaminewhether

Date:Feb4,2010

Time:2:41pm

youbuylowP/EstocksorhighP/Estocks.Themosttellinginforma-

tionaboutyourbehaviorwouldcomefromidentifyingtheeventsthat

triggeradecision,becauseadecisionisnotsomethingyoudreamup

fromnothing.Youshouldknowtheprincipalvariablesthattriggeryour

decision.Areyoumotivatedbythemarket,theevening

news,afriend’s

recommendation,orsomethingelse?Agoodinvestorshouldknowwho

heorsheis.Self-reflectioncanbechallengingbutveryrewardingtoan

investor.

CanYouChangeYourself?

Tobenefitfromthemarket’sgyrations,youneednotonlytounderstand

thebasicsofmarketpsychologyandyourselfbutalsotofindoutwhether

youcanchange.Ifyoufinditdifficulttochange,thenunderstandingmarketpsychologyoryourselfmaynotbeenough.Considerthefollowing

example.Sayyouacknowledgethatifyoudriveafterdrinkingalcohol

ataparty,youincreaseyourchancesofhavinganautoaccident.Itis

alsoimportanttoknow,though,whetheryoucanchangeyourbehavior

andcontroldrinking.Ifyoucannotchangeyourbehavior

attheparty

byrefusingtodrink,areyouwillingtochangeyourbehaviorafterthe

party?Canyouleaveyourcaratyourfriend’splaceandtakeataxihome?

Itisonethingtoknowtherightthingtodo;itisanothertochange

yourbehavior.BenjaminGrahamputsthissuccinctly:“Itiseasyforus

totellyounottospeculate;thehardthingwillbeforyoutofollowthisadvice.”3

Buffetthasoftenmentionedthatdifferentpeoplearewireddiffer-

ently.Forexample,hehasjokinglysaidthathewould

havebeenan

animal’slunchifhehadbeenbornafewhundredyearsago,implying

thathisskillsaremoresuitedtothemodernworld.Themainmessage

isthatitisnoteasytochange.AfterreadingBuffett’spartnershiplettersfrom1958to1969,his

annualletterstoshareholdersfrom1970to2008,

andmanyofhisarticles,IfindthatBuffetthasalteredverylittleinhisapproachtobusinessandinvesting.Thegoodthingabouthisconsistent

behavioranddecisionmakingisthatwecanlearnfromhisinvesting

practices.Thisdoesnotmeanthatonecanchangeeasilyandfollowhis

principles.EvenafteryearsofscouringBuffett’swritingsandgoingtotheE1C25

Date:Feb4,2010

Time:2:41pm

psychology

annualshareholdermeetings,Ilookatstockpricesseveraltimesduring

theday.IsometimesbuyorsellstockswithoutanalyzingthemaswellasIshould,andIoccasionallytradeoptions.ButIhavechangedsomewhat.I

havecertainlyrealizedthatit

takesmealongtimetochange.Thisseemstobeacommonphenomenon.

HowPsychologyMayHelpYou

InhishighlycelebratedbookTheAlchemyofFinance,GeorgeSorospointsoutthattheoutcomesinsocialsciencessuchaseconomicsarrivefrom

adifferentprocessthantheprocessesinnaturalsciences.4Innaturalsciences,onesetoffactsfollowsanotherwithoutinterference.Thescientistdoesnotinfluencetheprocess.Specifically,nothingthescientistdoeswillturnbasemetalsintogold.

Now,toconsiderthefinancialmarkets,let’suseanexamplesimilar

totheoneSoroscites.Assumethatunderreasonableconditions,Widget

Company’sstockpriceshouldbeabout20timesitsearningspershare.If

thecompany’searningspersharegoupfrom$0.80to$1,itsstockprice

shouldgoupfrom$16to$20

pershare.Ifallmarketparticipantsact

rationally,thepricemaygoupto$20andstaythere.However,financial

marketparticipantsdonotallbehaverationally.Asmarketparticipants

observestockpricesgoingupafterearningsincrease,morebuyersmay

comeinandthepricemayclimbhigherthan$20.Thefinalpricewill

dependontheavailabilityofmoney,participants’experienceswithother

investments,andperhapsevenweather(becausetheirmoodsmayvary

withtheweather).Themainpointisthattherelation

betweenearnings

andpricesintheshortrundependsonparticipants’perceptionsand

actions,notonfundamentalsalone.

Butthestorydoesnotendhere.Let’ssaythatthestockpricegoes

upto$30.Thecompany’s

managementmayevaluatethestockpriceand

concludethatitis,atthatpoint,overvalued.Thecompanymaythenuse

itsstockasacurrencytobuyanothercompanyortoissuenewshares

atthishigherprice,whichgeneratesmorecashforthecompany.This

actionmayindeedpushtheintrinsicvalueofthecompany’sstockfrom

$20persharetoahigherprice.Ontheotherhand,ifthemanagerspay

ahighpriceforacquisitions,theremaynotbeanygaininintrinsicvalueE1C25

Date:Feb4,2010

Time:2:41pm

andtheremayactuallybealoss.Themanagers’behaviormaydetermine

whetherthecompanybecomessuccessfulorwastesthenewlyacquired

resources.Thefinaloutcomeisgenerallynoteasytopredict,butitis

usefultothinkintermsofpossibleoutcomesandtotakeintoaccount

bothfundamentalsandpsychology.

InJanuary2000,arelativelynewbutsuccessfulInternetcompany,

AmericaOnline(AOL),announcedthatitwasbuyingtheestablished

publisherandmediagiantTimeWarner.Basedonthetradingprices

ofthetwocompaniesatthetime,thecombinedmarketvaluewould

be$350billion.InApril2009,thecombinedmarket

valuewasonly

$30billion.Inthistransaction,AOLuseditsovervaluedstockasa

currencytopurchaseTimeWarner.Thecombinedfirmwasnotas

successfulasmergerplanshadanticipated,buthadAOLnotengagedin

theacquisition,itmightnothavesurvivedasaviablecompanyatall.

Pricesdonotfollowfundamentalsalone,becauseinvestorsoften

wanttogetrichquicklywhenthemarketisrising(greed),andthey

wanttoprotecttheirinvestmentvaluewhenthe

marketisfalling(fear).

Inarisingmarket,initialpricechangesmayleadtofurtherpricechangesasinvestorspourin,whichthenmakesthemarketovervalued.Onthe

otherhand,whenpricesarefalling,moresellerscometothemarketto

protecttheirinvestmentsand

themarketbecomesundervalued.Nobel

LaureateGeorgeAkerlofandRobertShillerdescribethisphenomenon

asprice-to-pricefeedbackleadingtoaviciouscircleofpricesgoingup

orgoingdownforawhile.5

Markettrendsleadingto

bubblesandbustsdonotlastforever;they

finallyreverse.Thereareseveralimplicationsforanaverageinvestor.First,abubble(overvaluation)usuallystartsinonesectoroftheeconomyand

thenspreads.Inthelate1990s,thebubbletookshapeinthehigh-tech

industry;andinthemid-2000s,thehousingindustryledthecharge.

Second,relativevaluationsmayoftennotbeagoodguideforinvesting.

Aftertheinitialriseofthehigh-techstockpricesduringtheInternet

bubble,mostotherstocksalsobecameovervalued.AsI

notedearlier,

evenCoca-Colawastradingata50P/Einthelate1990s.Third,it

seemsimpossible(atleasttome)totellhowlongabubbleorbearmarketwilllast.Finally,totakeadvantageofthesebubblesorbearmarkets,youshouldbuyorsellastockonlyafteryouhaveobjectivelycomputed

intrinsicvalueasdescribedearlierinChapter5.

Date:Feb4,2010

Time:2:41pm

psychology

HowtoThinkaboutPsychologicalBiases

Manypsychologicalstudiesshowthatthehumandecision-making

processisimperfect.Inparticular,individualsdeviatefromeconomic

rationality.Forexample,theymakedifferentchoicesdependingonhow

agivenproblemispresentedtothem.Individualsarealsoknowntovio-

lateseveralprinciplesofstatisticaltheory(forexample,Bayes’theorem)inpredictinguncertainoutcomes.

However,simplybecausesomeinvestorsplacealotofweighton

psychologicalfactorsandlessweightonfundamentalsdoesn’tmeanwe

shouldgetcarriedawaywiththeideathatthefinancialmarketsarecrazy.

Wedonotknowwhethertradingbyonegroupofirrationalinvestors,

onaverage,cancelsouttradingbyanothergroup.In

general,ifboth

optimistsandpessimiststradeinthemarket,theremaynotbeanydesta-

bilizingeffect.Itisdifficulttofindasmokinggunthatlinkspsychologicalforcesinindividualstomispricinginthemarketplace.Whileitisbeyondthescopeofthisbooktoexaminevariousmodelsinpsychology,itis

appropriatetodiscusssomeoftherelevantissues.Ingeneral,whenyou

readapsychologicalexplanationofmovementsinthemarket,evaluate

itrationallyjustasyouwouldevaluateasalesperson’spitchofaproduct.

Let’sstartwiththeso-called

overconfidencebias.Overconfident

peoplehaveatendencytooverestimatetheirskills.Thosewhothink

thattheycandrivewellevenafterdrinkingthewholenightaresimply

overconfidentintheirabilities.Iwanttouseoverconfidenceasanexam-

pletoshowthat,inmyopinion,overconfidenceinstock-pickingability

doesnotnecessarilymeanthatapersonwillpickwrongstocksandlose

alotinthestockmarket.Takethefollowingthoughtexperimentasan

example.

First,imagineasituationwhereapersonthinksthathecanpick

undervaluedstocksbutdoesnothavetheability.Evenifhedoesnot

haveasuperiorability,hewillnotnecessarilyunderperformthemarket.

Withoutanyabilitytopickundervaluedstocks,hewill

essentiallypick

stocksrandomlyasamonkeywould.Somestockswillunderperform

themarket,andotherswilloutperformthemarket.Overall,eveninthe

absenceofsuperiorstock-pickingability,hewilldojustfine—thatis,

hisperformancewillmatchthemarket’sperformance.

Date:Feb4,2010

Time:2:41pm

Nowconsideranotherpersonwhoisalsooverconfidentbuthassome

abilitynonetheless.Notallhispicksmaydowell,butmorethanfiveoutoftenwill,becauseofhisability.Assumethathepicks10stocksthatheis(over)confidentabout.Sincehehassomeskill,hewilloutperformthe

marketonaverage.Theresultwilldependonhisoverallabilitytofind

undervaluedstocks,notonhislevelofconfidenceinthem.Onaverage,

ifyouareabletopinpointundervaluedstocks,itdoesnotmatterwhetheryouarehighlyconfidentornotsoconfident.Thus,theoverconfidence

biasbyitselfisnotabadhumancharacteristicinpickingstocks.

Insomesituations,biasesmayindeedbedestructive.Onecommon

biasthatIalsohaveisthatofnotsellingastockataloss.Butifyoubelievethatthestockisovervalued,thenyoushouldsellevenifthe

currentpriceisbelowyourcostandyouhavetotakealoss.Professor

TerranceOdeanexaminedtradingrecordsfor10,000accountsatalarge

discountbrokeragehouseandfoundthatinvestorsarereluctanttorealizetheirlosses,whichmaybeonereasonfortheirunderperformancerelative

tothemarket.6Consideranotherbiasormisperception:comparingthe

stockmarkettoacasino.Ifyoubelievethatyoucandowellingamblingatacasino,youaremorelikelytobewrongthanright.Thestockmarket

foryoubecomesacasinowhenyoutrytotimethe

short-termprice

movements.Inthatcase,yourbeliefsmayleadyoutotradeexcessively,

andtradingcostswillharmyourperformance.7Similarly,ifyouare

bettingintheoptionsorfuturesmarkets,youmaylosebecausetime

isnotonyourside,andyouareprobablyplayingagainstthehouse.

Everyonehasbiases.However,youneedtothinkabouthowbiasesmay

affectyourbehaviorandwhetherthatbehaviorisharmful.

Wheredothesebiasescomefrom?Whiletheyprobably

havetheir

rootsinfactorssuchasgenesorgeography,let’sjustconsideronesource:youandyourownexperiences.IfyoulivedinSeattleandsawscoresof

softwareengineersbecomingmillionairesfromworkingforMicrosoft,

youwouldhavelinedupata

localuniversitytobecomeasoftware

engineer.Youmayhavedisregardedthepossibilitythatyoudidnothave

suitableskillstobecomeagoodsoftwareengineer.Maybeyoushould

havegonetolawschoolinstead.Similarly,ifyoulivedinFayetteville,

nearWal-Mart’sheadquarters,youwouldhavegivenyourlefthandto

workforWal-Martwhenitwasgrowingfast.

Date:Feb4,2010

Time:2:41pm

psychology

Whydopeoplebelievethatatrendinpriceswillcontinue?Probably

becauseoftheirownexperienceswithawidevarietyofchartssince

childhood,theynaturallyseepatternsevenwhentherearenone.Inmost

charts,whethertheydepictper-capitaincome,numberofcarsproduced

eachyear,orconsumerprices,thereisanoticeabletrend.InmostchartsthatIhavecomeacrossinmylife,thereisanupwardtrend.Giventhis

vastexperience,whenweobserveapricechart,weintuitivelyimagine

atrendevenwhenthereisnone.

Likewise,whydoinvestorsflocktoinvestingwithpreviouslysuc-

cessfulmutualfundswhenitiswellknownthatpastsuccessesgenerally

donotpredictthefuture?Onceagain,theyareprobablyreactingonthe

basisoftheirexperienceswithpatternsinlifeingeneral.Asuccessful

surgeoncontinuestobesuccessful,agoodmanagerremainsagoodman-

agerandmayevengetbetterwithage,agoodartistcontinuestobea

goodartist,andagoodresearchercontinuestobea

goodresearcher.But,thispatterndoesnotapplytomostmutualfundmanagersbecausethe

luckfactorloomslarge.8Overall,mostofusdonothaveenoughknowl-

edgeoftherightvarietytothinkindependentlyallthetime.Weform

biasesbecausewe

extrapolateknowledgefrompasttofutureorfrom

onefieldtoanother.However,ifyoureadwidelyandlearnfromothers’

experiencesbeyondyourown,youshouldbeabletoreduceyourbiases.

SomeImportantQuestionsforYoutoConsider

Thepurposeofunderstandingpsychologyistoreducetheirrational

componentinyourdecisionmaking.9Toapplypsychologyinyourstock

buyingandsellingdecisions,thefirstthingyoushouldexploreisyour

primaryreasonformakingthatdecision.Considera

situationinwhich

youdecidetobuyastockbecausethestock’sP/Eratioislow.Knowing

theprimaryreasonforyourdecision,youshouldaskyourself,“Isbuying

alowP/Estockrational?”Thereisplentyofevidenceintheliterature

tosuggestthatinthelongrun,buyingalowP/Estockresultsinhigher-

than-averagereturns.Thus,yourmotivationappearsrational.Youmay

havefollow-upquestions:“WhyistheP/Elow?”or“Whatpercentage

oflowP/Estocksactuallyoutperformsthemarket

withinthreeyears?”

or“HowlongshouldIholdastockafterIbuyalowP/Estock?”Because

Date:Feb4,2010

Time:2:41pm

yourealizethatyouarenotverypatient,youmaynotliketheanswer

thatyoushouldholdastockforthreetofiveyears,andyoumaydecide

nottoinvestinlowP/Estocks.

Inanycase,systematic

thinkingwillhelpyoudeterminewhatyou

knowordonotknowandovercomeyourpsychologicalbiases.When

youdonotknowtheanswer,youneedtomakeajudgmentcall.In

thecaseofbuyingalowP/Estock,youmightfindthatonepossible

reasonforthelowP/Eisthattheearningsaretemporarilyhigh.Itmay

notalwaysbepossibletogaugetheextenttowhichearningsaretem-

porarilyhigh,andyoumayhavetomakeajudgmentcallbasedonyour

knowledgeofavailablefinancialdata.Inestimating

theintrinsicvalue

ofBurlingtonNorthernSantaFeearlier,Ientertainedthispossibility

becausetheeconomywasdoingwelluntil2007.ButIamunabletotell

theextenttowhichearningsmaydecreasein2010or2011.Incomputing

intrinsicvalue,wehavetomakeestimatesorjudgmentcalls.Ultimately,

everyonehastomakejudgmentcalls,butfollowingasystematicapproach

willhelpyouknowwhenyouaremakingajudgmentcall.

Consideracompanythathasanexcellentproductlineandwhose

stockyouarethinkingofbuying.Youwillprobablyexaminethehistori-

calsalesgrowthorpastpricepatterns.Youwillalsolookatthecompany’sfundamentalsandmanagement;butfinally,youwillhavetomakeajudgmentcall.Youmightconcludethatyoudonotknowenoughaboutthe

company’sprospectsbutthatthepricelooksattractivebasedonwhat

youknow.Inotherwords,youdonothaveenoughconfidenceinyour

decision.Youmaydecidetoinvestonlyasmallamountofmoneyinthe

stockandrevisittheinformationsetafterafew

months.

Yourultimatequestionshouldalwaysbe“Isthisrationalbasedon

allthatIknow?”Onaverage,ifyougothroughasetofbasicquestions

aboutthestockandpsychology,youshoulddowellinthestockmarket.

Ofcourse,intheprocessoflearningaboutyourself,ifyouconcludethatyouarelikelytomakeirrationalchoicesmoreoftenthannot,maybeyou

shouldstayawayfromthestockmarket.Inthatcase,yoursituationmay

besimilartosomeonewhoknowsthedangersofexcessivedrinkingbut

cannothelpbutdrinkwhenhevisitsabar.Heshouldlearnnottogo

nearabar.Overall,knowledgeoffundamentalsshouldhelpyouestimate

thecompany’slong-termfuture,andknowledgeofpsychologyshould

helpyouinjectrationalityintoyourdecisions.

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psychology

Conclusions

Everyonehasopinionsandpsychologicalbiases.

However,peoplemay

notknowtheirownbiases.Themoreyouknowaboutyourpsycho-

logicalbiases,thebetteryoucanfunctioninthevolatilestockmarket.

Theentiremarketmaybeinfluencedbypsychologicalreasons,notby

fundamentalreasonsalone.Fromaninvestmentperspective,thebot-

tomlineisthatthemarketwillcontinuetofluctuateandgiveyou

solidopportunitieseverysooften.Valueinthelongrunisdetermined

byfundamentals,whileshort-termgyrationsreflect

marketparticipants’

psychologicalweaknesses,suchasherding.Knowledgeisthebestanti-

dotetomakingwrongdecisions.Ifyouarealong-terminvestor,the

rationalthingtodoistomakedecisionsbasedonlong-termfundamentals

ofthebusiness.

Date:Jan18,2010

Time:10:57pm

Chapter26

HowtoLearn

fromMistakes

Whatwelearnfromhistory

isthatpeopledon’tlearnfrom

history.1

—WarrenBuffett

BothWarrenBuffettandCharlieMungerbelieveinlearningfrom

mistakes.DuringBerkshire’s1997annualmeeting,Mungersaid

thatinthepast,Berkshire

boardmembershavediscussedtheir

mistakestolearnfromthem.Membersbroughtuponeortwoimportant

mistakestheyhadmadeintheircareers.Mostofusfinditeasytotalk

aboutoursuccessesbutdifficulttotalkaboutourmistakes,andoftenwe

attributeourmistakestobadluck.

MistakesversusBadLuck

Weshoulddifferentiatemistakesfrombadoutcomesorbadluck.Abad

outcome,forexample,wasthedropinthestockpriceofJohnson&

JohnsonwhenTylenolwas

foundtobelacedwithpoisonandseveral

consumersdied.2IfyouhadownedJohnson&Johnsonstockthen,it

wasbadluck,notamistake.WhenSalomonBrothersgotintotroublein

1991,BerkshireHathawaysufferedfinancially,andBuffettalsosuffered

Date:Jan18,2010

Time:10:57pm

psychology

personallywhenhetookoverastheCEOofSalomonto

sortoutthe

problems.ThescandalatSalomonthatledtoBuffett’sinvolvementwas

arareevent,andsotherewasverylittletolearnfromit.ItwasalmostimpossibletopredicttheSalomonscandal.Itwassimplybadluck.

Itisalsonotamistakewhenyouconsciouslydecidenotto

somethingthatturnsouttobegoodluck.Forexample,ifyoudonot

participateinyourofficelotterypoolandthepoolwinsamega-million-

dollarjackpot,youhavenotmadeamistake.Althoughaclosefriendof

BillGates,Buffettissaidtohaveboughtonly100sharesofMicrosoft.

WasBuffettmistakeninnotinvestingmoreinMicrosoftstock?No.

Buffetthasconsciouslydecidednottoinvestoutsidethecirclesofhis

competence.

NordidBuffettbuysharesinFannieMaeinthemid-1980sbefore

thestockdidverywell.InoneofBerkshire’sannualmeetings,hesaidthatnotbuyingFannieMaewasamistake.Buffettknowsalotaboutfinancial

companiesandfeltheshouldhaveknownthat,ultimately,FannieMae

waslikelytobesuccessful.From2006to2008,Berkshireinvestedmore

than$7billioninConocoPhillipsstockwhenoilandgaspriceswerenear

theirpeak.Thestockpricesubsequentlydroppedby50percent.Inthe

2009annualmeeting,Buffettmentionedthatbuyingthe

ConocoPhillips

stockwasamajormistake.

LearningfromMistakes

In1965,BuffetttookcontrolofBerkshireHathaway.Ondifferentocca-

sions,hehasmentionedthatitwasamistake.Heknewthattheprospects

oftextilemanufacturingwereunpromising,butheboughtitbecausethe

stockpricelookedcutrate.(Hemayhavealsoboughtitforitscashflows.)Helearned,Ibelieve,thatreasonablegrowthprospectsareimportant.

Healsoseemstoavoidhigh-capital-intensitybusinessessincethenunlessheisina

positiontoinfluencemanagerialdecisionsbyholdingalarge

stakeinthecompany.

Weoftenmakemistakesbecausewedonotthinksystematicallyabout

ourdecisions.MichaelMauboussin,chiefinvestmentstrategistatLegg

Mason,recommendscreatingalisttoconcentrateonstepsneededto

Date:Jan18,2010

Time:10:57pm

makeagooddecision.3Onmanyoccasions,Ihaveaskedmyfriendsif

theyhadmadeamistakebynotinvestinginBerkshire.Someofthem

answeredyes.However,whenIaskthemwhattheyhavelearnedfrom

thatmistake,theyusuallydrawablank.Making

mistakesisnotabad

thing,notlearningfromthemis.Myusualsuggestiontomyfriendsis

toexaminewhetherBerkshireisstillagoodstock.IfBuffetthasbeensogoodinthepast,shouldwehavesomeconfidencethathewillproduceat

leastreasonablygoodresults

inthefuture?Thissequenceofquestioning

ledmetocontinuetoinvestinBerkshire.Inearly2009,Iboughtmore

ofBerkshirestockwhentheclassBsharesweretradingataround$2,500

pershare.

Learningfrominvestment

mistakesiseasierwhenyouarealready

somewhatknowledgeableabouttheindustryinwhichyouinvest.For

example,ifyouknowsomethingaboutretailingandyouinvestinTarget

orWal-Mart,youwillhavetheopportunitytolearnfromyourinvest-

ments.Inthelate1990s,IinvestedinKmartbecausethestocklooked

cheapandIwasexpectingthecompanytogrow.However,Isuffered

significantlosses.Ishouldhavevisitedthestoresmorefrequentlyto

examinethequalityofcustomerserviceandthe

availabilityofprod-

ucts.Later,IalsolearnedthatKmart’slowinventoryturnoverratiowas

oneindicationthatthecompanywasnotdoingwell.Thismistakehas

nudgedmetobecomebetterinusingfinancialratios.Myknowledgein

accountingandfinancehashelpedmeinthisregard.Thus,expertiseand

learningfrommistakesgohandinhand.Thisisoneadditionalreason

thatinvestorsshouldinvestintheircirclesofcompetence.

Thefirststepinlearningfrommistakesisto

acknowledgethata

mistakewasmadeandbyitself,makingmistakesisnotabadthing.4To

avoidfuturemistakes,Iwritedownmyerrorsintheprivacyofmyhome.

Second,Iwritepotentialreasonsformymistakes.OnceIhaveanalyzed

thereasons,Itakethethirdhardstepoftalkingaboutmymistakestomyfriends.Ievenhangthenow-worthlessKmartsharecertificateonmy

officewall.IusedtobuyandsellfrequentlyafterreadinganarticleintheWallStreetJournalorBarron’s.Butnow,throughthisconstantwritingandevaluationprocess,Iammuchless

likelytobuyorsellonawhim.Most

ofmyholdingsarenowlong-termholdings.WheneverIfeellikeselling

mylong-termholdingsofBerkshireHathaway,Wal-MartdeMexico,

Date:Jan18,2010

Time:10:57pm

psychology

andAmericanExpress,IgobacktothereasonsIboughttheminthe

firstplaceandevaluatecurrentconditions.

MistakesofCommission

andMistakesofOmission

BerkshireHathawaypurchased200millionsharesofCoca-Colaforabout

$6.50pershare(split-adjusted)inthelate1980s.DuringtheInternet

bubbleperiodinearly1998,theCoca-Colastockpricewas$85per

share,which,bymostvaluationmetrics,wasovervalued.Forexample,

theP/Eratiowasover50.BuffetthassubsequentlyhintedthatnotsellingBerkshire’sCoca-Colastockwasamistake.By2003,thestockpricehad

fallento$40,andinearly2009,itwasstilltradingataround$45per

share.Wedon’tknowwhyBuffettdidnotsellthestock,butwecan

speculateandpossiblylearnfromthisepisode.

First,BuffettwasadirectorontheCoca-Colaboardofdirectors.Any

directorwouldfinditdifficulttosellahugepositioninthecompany

stock.Buffettresignedfromhisdirectorshipin2006after17yearsontheboard.Second,itispossiblethatwhenacompanyhassignificantcash

flowsasBerkshiredoes,evenpeoplelikeBuffettmaynotbeattentiveto

thepriceofaninvestment.Afterall,theideainlong-terminvestingis

nottofocusontheday-to-dayprice.Finally,itisworthmentioningthatifBuffetthadsoldtheCoca-Colastockatclosetoitspeak,sayin1999

or2000,andinvestedtheafter-taxproceedsinthemarketindex,the

lossesby2009wouldhavebeenaboutthesame.Thisisagoodexample

tothinkaboutwhenyoulookatyourownmistakes;themainlesson

probablyisthatyoushouldsellastockwhenitisclearlyovervalued.I

alsodonotknowwhyBuffettboughtConocoPhillipsstockandthen

soldit.Myguessisthatherealizedthatbecauseofhigh

volatilityinoilprices,oilcompanystockpricesarespeculativeinnature.

Buffetthasoftentalkedaboutmistakesofomission—theinvestments

thatshouldhavebeenmadebutwerenotmade.Inoneinstance,he

discussednotbuyingWal-Martstock,whichwasinhis

circleofcompe-

tence.Itwasnotahigh-techcompany,anditwasgrowingsuccessfully

intheU.S.MidwestwherehishometownofOmahaislocated.Ithink

itwouldhelpusallifwelearnedtoevaluateourmistakesnotonlyof

commissionbutalsoofomission.

Date:Jan18,2010

Time:10:57pm

Conclusions

Everyonemakesmistakes,andbadluckstrikeseverywhere.Thereisnot

muchyoucandoaboutbadluckexcepttodiversifyandshyawayfrom

hugerisks.Whenyoudomakemistakes,takethetimetoponderthem

andfindwaystoavoidmakingthesameonesagain.

Date:Jan18,2010

Time:10:57pm

E1PART09

Date:Dec10,2009

Time:3:32pm

PartNine

CORPORATE

GOVERNANCE

HowdoesBuffettsuccessfullymanagealargeconglomerate?

Whenyouthinkaboutinvestinginthestockmarket,you

shouldalsoconsiderthequalityofcorporategovernanceprac-

ticesatthefirm.InChapters27through30,Ireviewseveralprinciples

thatBuffetthasadoptedinrunningBerkshireHathaway.

E1PART09

Date:Dec10,2009

Time:3:32pm

Date:Jan29,2010

Time:2:33pm

Chapter27

Dividends:DoThey

MakeSenseinThis

DayandAge?

[D]ividendpolicyis

irrelevantforthedeterminationofmarket

prices,giveninvestmentpolicy.1

—MertonMillerandFrancoModigliani

Thepracticeofpayingregulardividendsisalong-standingpuz-

zle.Inawell-knownarticle,twoNobellaureatesin

economics,

FrancoModiglianiandMertonMiller,wrotethatacompany’s

valuedoesnotdependonitsdividendpolicy;rather,valuedependson

howthecompanyinvestsitsresources.Afterall,dividendsareequivalenttotransferringshareholders’

moneyfromtheiraccountswiththecompanytotheirpersonalaccounts.Whenacompanypaysadividend,its

sharepricedropsbyalmostthesameamountasthedividend.

BerkshireDoesNotPayDividends

Buffettseemstoagreewithacademicthoughtonthe

topicofdividends.

BerkshireHathawayhasnotpaidanydividendsforthepast42years.MIT

Date:Jan29,2010

Time:2:33pm

corporategovernance

professorandGoldmanSachspartnerFischerBlackarguedthatbecause

oftheU.S.double-taxationstructurewherecorporationsfirstpaytaxes

onearningsandthen

individualsagainpaytaxesondividends,both

corporationsandindividualsshouldprefernodividends.2Corporations

shouldonlyreturnearningstotheirshareholdersascashdividendswhen

theydonothaveprojectswithreasonableratesofreturnandtheirown

sharepricesarehigh.Ifthesharepriceislow,theyshouldrepurchase

theirownshares.

ConsiderCitigroup,alargefinancialinstitutionwithamarketcap-

italizationofabout$200billioninlate2007.Itscommonstockwas

amongthehighestdividend-yieldingstocks,payingstockholders7per-

cent.During2007,thestockpricedeclinedbyover40percentbecause

thecompanysufferedlossesofabout$10billioninitshousing-related

investments.InthewakeofCitigroup’sdecline,CEO

CharlesPrincehad

toresign.Toregainitsfinancialstrength,Citigroupissued$7.5billionofconvertiblesecurities,yielding11percenttotheAbuDhabiInvestment

Authority.Byanyyardstick,11percentishigh,inlightofthefactthatthegoingrateofintereston10-yearTreasurynotesatthetimewasonly

4.25percentandthe30-yearmortgagerate,about5.8percent.

AlthoughCitigroup’sstockpricehaddeclinedandthecompanywas

forcedtoraisefunds,itcontinuedtopayalmost$10billionayearin

dividends.ItwasobviousthatCitigroupneededcashin

ahurry:The

marketdidnotthinkhighlyofCitigroup’sfinancialstrengthbecauseof

thehugelossesithadincurred.WhydidCitigroupnotcutitsdividends

immediatelywhenitwasobviouslyinseriousfinancialtrouble?Some

havearguedthatonceacompanystartspayingadividend,themarket

expectsthecompanytopaythedividendatregularintervalsforever.

Thisargumentmayhavesomejustificationinnormalcircumstances,

butthelogicisquestionableinthiscase.Sincethe

companyalready

indicatedthatitwasinfinancialtroubleandneededtoraisefundsby

issuingpreferredstock,adividendcutwouldhavebeenamorelogical

choicethanraisingequity.WhileCitigroupisanextremeexample(and

itfinallycutitsdividend),itiscommonforcorporationstoraiseequityandpaydividendsatthesametime.Suchcasesareoftenexamplesof

poorfinancialmanagement.

Receivingregulardividendsiscostlytoyou.First,ifyouownshares

inyourname,youreceive

checkseveryquarterthatyouthenhaveto

Date:Jan29,2010

Time:2:33pm

Dividends:DoTheyMakeSenseinThisDayandAge?

taketothebank,spendingtimeonthischore.Depositingofdividends

canbemadeautomaticifyouownsharesinabrokerageaccount,but

manypeopleprefertoholdsharesthemselvesbecausetheyaresaferthat

way.Second,youhavetospendmoretimeandeffort

keepingtrackof

yourdividendsfortaxpurposes.Finally,youhavetopaytaxesonthese

dividends,oftenataratehigherthanthecapitalgainstaxrate.Ifsomeshareholdersneedregularinfusionsofcash,itisnotclearthatwhattheyreceiveindividendsistherightamountforthem.Shareholderscaneasilysella

fewsharesiftheyneedcash.Also,shareholderscandecidewhich

sharestoselltominimizetheirtaxburden.Perhapssomeintermediaries

andconsultantswhogiveadviceondividendsearnfees,andthatmay

beonereasonmostcompaniescontinuetopay

regulardividendsinthis

dayandage.

Sowhatshouldyoulookforinadividendpolicy?Aregulardividend

paymentfromacompanythatgeneratesregularfreecashflowsbutdoes

nothavegrowthopportunitiesindicatesa

companywithself-disciplined

management.Inacademicfinance,thisisknownasthemonitoringrole

ofdividends.Becauseofthecommitmenttopayregulardividends,suchcompaniesarelesslikelytowasteresourcesandaregoodcandidatesfor

furtheranalysis.Costcostartedin1983anduseditscashflowsforgrowthuntil1994,whenitstartedpayingdividends.Itwasagoodcompanyto

investinbeforeitpaidanydividendsandalsoafteritstartedpayingregulardividends.Ifyouhadfocusedonlyondividend-payingcompanies,

youwouldhavenotinvestedinCostcoorforthatmatterinBerkshire

Hathaway.

Aregulardividendpaymentbyitselfisnotastrongenoughvariable

tocharacterizeacompanyasagoodinvestment.Whenacompanypaying

regulardividendsalsoraisesfundsinthefinancialmarketsandthebal-

ancesheetisnotstrong,youshouldbecarefulaboutinvestinginitsstock.

Dividendpaymentisjustonepossibleuseoffreecashflows.Whatismostimportantisyourcomfortlevelwithacompany’susageofitsfreecash

flows.Companieshavemanychoicesotherthanpayingdividends:They

canundertakenewprojects,repurchasetheirownshares,andinvestin

financialassets.Ifyouarenotcomfortablewithmanagementdecisionson

itsusageofcashflows,especiallyitsinvestment

policy,youshouldnotbuythestockinthefirstplace.Ifacompanyhasexcesscashwithoutareasonableprobabilityofprofitablenewprojects,itcandowhatMicrosoftdid.

Date:Jan29,2010

Time:2:33pm

corporategovernance

MicrosoftandaSpecialDividend

Microsoft’spolicypresentsagoodexampleofwhatacompanycanperi-

odicallydowithexcesscash.ItisclearthatMicrosofthas

beenhighly

profitable(seeTable27.1).Insteadofpayingregulardividends,thecom-

panyrepurchasesitsownshares.Byrepurchasingitsownshares,Microsoftiseffectivelyreturningcashtoitsshareholderswithoutmakingthem

liableforadditionaltaxes.

Second,Microsoftdoesnothavetorepur-

chaseitssharesveryoften;itdoessoonlyperiodicallywhenithasexcesscashandthestockpriceislow.

Bytheendof2002,Microsoftwasinanenviablefinancialposi-

tionwithabout$70billionincashandshort-term

investments.Itwas

increasinglybeingcriticizedfornotpayingcashtoitsshareholders.In

2003,Microsoftpaiditsveryfirstcashdividend:$857million,orabout

10percentofitscurrentearnings.WhydidMicrosoftstartpayinga

Table27.1

Microsoft’sEarningsandReturnofFunds(DividendsandShare

Repurchases)toShareholders

Dividends

Fiscal

Repurchaseof

paidto

returnedto

Earnings

ownshares

shareholders

$2,195

$1,344

12,254

36,112

44,169

12,599

19,207

22,752

14,065

27,575

31,380

1996–2007

$94,663

$91,582

$46,048

$137,630

Date:Jan29,2010

Time:2:33pm

Dividends:DoTheyMakeSenseinThisDayandAge?

regularcashdividend?Themotiveisuncertain,butMicrosoftmayhave

donesoinresponsetodemandsfromthemedia.Theinitiationofcash

dividendscertainlyhelpedreducecriticism.Theamountoftheregular

dividendisnotlargerelativetoMicrosoft’searningsorits

cashandshort-terminvestments.In2005,thecompanyused$44billiontorepurchase

sharesandtopayaone-timedividendinexcessof$36billion.Inrecent

years,IhavenotseenanycriticismofMicrosoftforitsdividendpolicy.

Maybethemainreasonfora

regulardividendpaymentisthemisguided

perceptionamongmanyinvestorsthatdividendsarealwaysgoodfor

shareholders.

Conclusions

Inmostcases,companiespayregulardividendssimplybecauseithas

beenalong-standingcorporatepractice.Therearenostrongreasonsto

supportpayingregulardividends,however,especiallywhenthebalance

sheetisnotstrong.Insteadoffocusingonthedividendpolicy,youshouldspendmoretimeanalyzingthesourcesandusesofacompany’scashflows,

whichultimatelydeterminethestockprice.

Date:Jan29,2010

Time:2:33pm

Date:Jan29,2010

Time:2:52pm

Chapter28

ShouldYouInvestin

CompaniesThat

RepurchaseTheir

OwnShares?

Companiesinwhichwehaveourlargestinvestmentshaveall

engagedinsignificantstockrepurchasesattimeswhenwide

discrepanciesexistedbetweenpriceandvalue.1

—WarrenBuffett

Whenapubliclytradedcompanybuysitsownshares,the

outcomeisasmallernumberofshareholdersowningthe

business.Throughrepurchases,thecompanymaysignal

thatitssharesareundervalued.Repurchasesarealsoatax-freemethod

toreturncashtoshareholders.Theacademicliteraturesupportstheview

thatcompaniesrepurchasingtheirownsharesare

frequentlyunderval-

ued.InanarticleintheJournalofBusinesspublishedbytheUniversityofChicago,AmyDittmarconcludes,“Firmsrepurchasestocktotake

advantageofpotentialundervaluation.”2

Date:Jan29,2010

Time:2:52pm

corporategovernance

ShareRepurchasingIsGoodNews

SupposeyouandJohnjointlyownatractofancestralland.Youdivideit

intotwoequalpartsforfarmingpurposes.Eachofyoucanfarmwhatever

youwantandkeeptheoutputs.Inhispieceofland,Johncultivates

cotton.Youuseitforsugarcane.Afterseveral

years,Johnproposesto

buyyourpieceofthelandatanattractiveprice.Whetheryousellor

not,itshouldbeimmediatelyclearthathiscottonfarmingisdoingwell.

Throughhisdesiretoincreasehislandholding,hehasrevealedtoyou

thatheisinaprofitablebusiness.Sharerepurchasingissimilar.

Investorscaninferthatacompanythatrepurchasesitssharesfre-

quentlyisunlikelytowastefreecashflowinunproductiveacquisitions.

ConsiderthecaseofCoca-Cola,whichhashad

significantfreecash

flowsinrecentdecades.In1982,itacquiredColumbiaPictures.The

Columbiaacquisitiondidnotworkoutandwassoldin1989.Buffett

explained,“Corporateacquisitionprogramsalmostneverdoaswelland,

inadiscouraginglylargenumberofcases,failtogetanythingcloseto

$1ofvalueofeach$1expended.”3Coca-Colasubsequentlydecidedto

investitscashflowsinitselfbypurchasingsomeofthesharesback.From1989to1999,thenumberofthecompany’scommonsharesoutstandingdecreasedfrom

2.79billionto2.49billion—adropof11percent,

orabout1percentperyear.Atcurrentprices,thisamountstoabout

$1billionannually.

ShareRepurchasesbyCompaniesinWhich

BerkshireHasInvested

InTable28.1,IexaminetherepurchasepracticesofsomeBerkshire

holdings.Thesedataareforthefive-yearperiodfrom2004to2008.

ThefivecompanieslistedinTable28.1invested34percentto

76percentoftheirnetincomeinpurchasingtheir

ownsharesback.

Iftheirmanagementqualityhadnotbeenexcellent,themanagers

wouldprobablyhaveusedthecashtoexpandtheirempiresbyinvest-

inginother,potentiallylessprofitable,projects.WashingtonPost,WellsFargo,andMoody’shave

engagedinrepurchasepractices.Inthecase

Date:Jan29,2010

Time:2:52pm

CompaniesThatRepurchaseTheirOwnShares

Table28.1

BuffettLikesCompaniesBuyingTheirOwnShares

Repurchasesas

Netincome

Repurchases

apercentageof

Company

(2004–2008)

netincome

Coca-Cola

$26,587

$9,164

AmericanExpress

17,597

13,314

Anheuser-Busch

Burlington

NorthernSantaFe

13,848

ofWashingtonPost,thecompanymadeasignificantinvestmentin

Kaplan,acommercialtrainingcompany,anddidnotbuybackshares

in2004and2005.However,

itrevertedtoasharerepurchaseprogramin

Buffettwrites:

Bymakingrepurchases,whenacompany’smarketvalueiswellbelow

itsbusinessvalue,managementclearlydemonstratesthatitisgiven

actionsthatenhancethewealthofshareholders,ratherthantoactions

thatexpandmanagement’sdomainbutthatdonothingfor(oreven

harm)shareholders.4

Hecontinues:

Investorsshouldpaymoreforabusinessthatislodgedinthehands

ofamanagerwithdemonstratedpro-shareholderleaningsthanfor

oneinthehandsofaself-interestedmanagermarchingtoadifferent

drummer.5

Sometimes,sharerepurchasescanboostreportedearningsbecause

thenumberofsharesgodownduetorepurchasing.Beforeinvestingin

acompanythatisrepurchasingitsownshares,youshouldinvestigatethe

companyfundamentalsanditsmanagementquality.

Date:Jan29,2010

Time:2:52pm

corporategovernance

WhyDoesn’tBerkshireRepurchaseItsOwnShares?

Inearly2000,whenBerkshireHathawayclassAcommonstockwas

tradingatabout$40,000pershare,downfromahighof$81,000per

share,manyarticlesinthepopularpresssuggestedthatBerkshireshould

considerrepurchasingitsownshares.Givenwhat

Buffetthasexpressed,

itseemedtobeareasonablesuggestionbecausethestockpricewas

barelyaboveitsbookvalueof$38,000pershare.Theannualletter

toBerkshireshareholderswaswidelyanticipated,andwhenitfinally

appearedonMarch11,2000,itfurtherclarifiedBuffett’sthinkingon

sharerepurchases:

Thereisonlyonecombinationoffactsthatmakesitadvisablefor

acompanytorepurchaseitsshares:First,thecompanyhasavailable

funds—cashplussensibleborrowingcapacity—beyondthenear-term

needsofthebusinessand,second,findsitsstocksellinginthemarket

belowitsintrinsicvalue,conservatively-calculated.6

Ifprofitableinvestmentopportunitiesexist,thenmanagementshould

notrepurchasethecompanysharesevenwhenthepriceisattractive.This

isprobablyonereasonBuffettdidnotchoosetorepurchaseBerkshire

shares.Ofcourse,evenBuffettadmitsthathehasmademistakesinthe

past,forwhichhehascriticizedhimself:“At

certaintimesinthepast,Ihaveerredinnotmakingrepurchases.MyappraisalofBerkshire’svaluewasthentooconservativeorIwastooenthusedaboutsomealternative

useoffunds.”Investorsshouldalsoconsiderthepotentialvalueadded.

Buffettcontinues,“Arepurchaseof,say,2%ofa

company’ssharesat

a25%discountfromper-shareintrinsicvalueproducesonlya1/2%

gaininthatvalueatmost.”Thus,whenmanagementreputationiswell

established,asinBuffett’scase,theadvantageinrepurchasingmaynotbesubstantial.Buffettfurther

emphasizeshisinterestinshareholderwealth:

“Pleasebeclearaboutonepoint:WewillnevermakepurchaseswiththeintentionofstemmingadeclineinBerkshire’sprice.Ratherwewill

makethemifandwhenwebelievethattheyrepresentanattractiveuseof

theCompany’smoney.”7Overall,ifacompanypurchasesitsownshares

onaregularbasisanditsfundamentalsappearsound,youshouldconsider

buyingsharesinthecompany.

Date:Jan29,2010

Time:2:52pm

CompaniesThatRepurchaseTheirOwnShares

Conclusions

Whenacompanybuysitsownsharesandyouhaveconfidenceinthe

qualityofthatcompany’s

management,chancesarethatthestockis

undervalued,andyoushouldexpectthestockpricetoriseovertime.

Ontheotherhand,iftherepurchaseofstocksseemstobemotivatedby

adesiretoreducethenumberofsharesand,hence,increaseearningsper

share,youshouldavoidinvestinginthecompany.

Date:Jan29,2010

Time:2:52pm

Date:Jan19,2010

Time:9:9am

Chapter29

CorporateGovernance:

Employees,Directors,

andCEOs

WarrenBuffett’sannualsalaryfor2008was$100,000andhis

totalcompensationwas$175,000.

—BerkshireHathawayProxyStatement,2009

WarrenBuffetthasoftenremarkedthathelovestorunBerk-

shireHathaway.Why?Itiscertainlynothis$100,000salary

thatmotivateshiminhisrolesasBerkshireHathaway’s

CEOandchairmanofthe

board.Onenecessaryingredienttoensurethe

successofanyorganizationistohavemotivatedemployeesandtopman-

agement.ThischapterexplainsthesalientfeaturesofBuffett’sthinking

onhowtomotivateemployees,directors,andCEOs.

EmployeeCompensationatBerkshire

In1996,BerkshireacquiredtheautoinsurerGEICO.Immediatelyafter

thepurchase,afocusedcompensationplanwasputinplace.Examining

thissimplebuteffectivechangebyBuffettgivesusinsightintopractices263

Date:Jan19,2010

Time:9:9am

corporategovernance

designedtomotivateemployees.Theobjectiveofthecompensation

planwastokeepemployeesfocusedonthoseaspectsofthebusinessthat

areundertheircontrolandthathaveanimpactonprofitability.Buffett

writes,“AtGEICO,thebonusesreceivedbydozensoftopexecutives

arebasedupontwokeyvariables:(1)growthin

voluntaryautopolicies;

and(2)underwritingprofitabilityonseasonedautobusiness.EveryoneatGEICOknowswhatcounts.”1

Whenacompensationplanisthatsimpleandfocused,dramatic

resultsensue.ThefollowingreflectionbyBuffettprovidesuswithaset

ofprinciplesinthisregard:

Berkshire’sincentivecompensationprinciples:Goalsshouldbe(1)tai-

loredtotheeconomiesofthespecificoperatingsystem;(2)simplein

charactersothatthedegreetowhichtheyarebeingrealizedcanbe

easilymeasured;and(3)directlyrelatedtothedailyactivitiesofplan

participants.2

Buffettalsoarguesthatcompensationplansshouldencourageahigh

returnoncapitalemployed,notjustahighlevelofprofits,becauseit

maybeeasytoincreasethelevelofprofitsbysimplyincreasingthe

amountofcapitalemployed.Inaddition,thecostofcapitalmustbetakenintoaccount.RecallBerkshire’shighlysuccessfulsubsidiaryScottFetzerCompany(discussedinChapter13)withRalphScheyasitsmanager.

BuffettexplainshowSchey’sbonusplangiveshimincentivestoincrease

theprofitabilityofcapitalemployed.

WritesBuffett:

IfRalphcanemployincrementalfundsatgoodreturns,itpayshimto

doso:Hisbonusincreases

whenearningsonadditionalcapitalexceed

ameaningfulhurdlecharge.Butourbonuscalculationissymmetrical:

Ifincrementalinvestmentyieldssubstandardreturns,theshortfallis

costlytoRalphaswellastoBerkshire.Theconsequenceofthistwo-

wayarrangementisthatitpaysRalph—andpayshimwell—tosend

toOmahaanycashhecan’tadvantageouslyuseinhisbusiness.3

Notethatitisnotsufficienttorewardmanagersonlyifperformance

isbetterthanexpected;managersshouldalsoreceive

incentivestoavoid

losses.Thisconceptofsymmetricalincentivesisrareinpractice.One

Date:Jan19,2010

Time:9:9am

CorporateGovernance:Employees,Directors,and

consequenceoftherarityofsymmetricalincentivesystemsisthat,when

possible,managersmanipulateaccountingnumberstoreporthigher

numbers,inordertoearnhigherbonuses.However,

thesemanagers

alsoattempttoreportlargerlossesinyearswhentheydonotexpectto

earnbonuses.4Whenyoustudyacompany’sincentivecontracts,look

forsymmetricalincentiveplans.

Buffettsummarizeshis

overallmanagementphilosophy:

AtBerkshire,ourmanagerswillcontinuetoearnextraordinaryreturns

fromwhatappeartobeordinarybusinesses.Asafirststep,theseman-

agerswilllookforwaystodeploytheirearningsadvantageouslyintheir

businesses.Whatisleft,theywillsendtoCharlieandme.Wethenwill

trytousethosefundsinwaysthatbuildper-shareintrinsicvalue.Our

goalwillbetoacquireeitherpartorallofbusinessesthatwebelieve

weunderstand,thathavegood,sustainableunderlying

economics,and

thatarerunbymanagerswhomwelike,admireandtrust.5

Buffett’sphilosophysuggeststhatpeople,ratherthanthetypeof

industry,arebehindextraordinaryresults.Berkshiregetsextraordi-

naryresultsfromitssubsidiaries,whichrangefromautoinsurance

tohonest-to-goodnesstraditionalbusinesses,becauseBerkshirecreates

compensationplanstailoredtothosespecificbusinesses.Unlikeprac-

ticesinmostlargecorporations,compensation

plansatBerkshirearenotlinkedtoBerkshire’soverallperformance.

CompensationforDirectorsandExecutiveOfficers

Berkshire’sprogramforcompensatingitsdirectorsalsodiffersfromcom-

pensationprogramsatmostpubliccompanies.Berkshirepaysnominal

amountstothedirectorstoattendboardmeetings.Adirectorwhois

notanemployeeoraspouseofanemployeereceivesafeeofonly$900

foreachmeetingattendedinperson,and$300forparticipatinginany

meetingconductedbytelephone.Incomparison,

directorsinlargecor-

porationsarefrequentlypaidmorethan$100,000incashcompensation

and$200,000intotalcompensation.Furthermore,theBerkshireCom-

pensationCommitteehasestablishedapolicythatneithertheprofitabilityE1C29

Date:Jan19,2010

Time:9:9am

corporategovernance

ofBerkshireHathawaynorthemarketvalueofitsstockisconsideredin

thecompensationofany

executiveofficer.Underthecommittee’scom-

pensationpolicy,Berkshiredoesnotgrantstockoptionstoexecutive

officers.

HowdoesBerkshireattractoutstandingdirectors?Thekeyseems

tobethat,inidentifying

potentialdirectors,Buffettlooksforindi-

vidualswhoare“owner-oriented,businesssavvy,interested,andtruly

independent.”6Thelastcriterion,“trulyindependent,”requiressome

elaboration.Itiseasyforaboardmembertomeettheindependence

criteriasetupbytheNationalAssociationofSecuritiesDealersorotherinstitutions.ButforBuffett,whatmattersis“trueindependence.”For

example,supposeauniversityprofessorisappointedasadirectorofa

publiclytradedcompanyandreceivescompensationof$100,000.Since

theincomederivedfromhisboardmembershipislikelytobeasub-

stantialportionofhisorhertotalincome,thecompanyCEOcanexert

significantinfluenceonthatboardmember.AccordingtoBuffett,this

boardmembercannotbeconsideredtrulyindependent.

MostBerkshire

boardmembersareaccomplished,wealthybusinessleaderswhoarelikely

tobe“trulyindependent,”byBuffett’sstandards.Theyarealsoowner-

oriented,asBuffettexplains,“Mostofourdirectorshaveamajorportionoftheirnet

worthinvestedinthecompany.Weeatourowncooking.”7

Thereisonecaveat:Whenalldirectorsthinksimilarly,theymay

ignorenewideasthatoftencomefromoutsiders,suchasprofessorsor

entrepreneurs.Inotherwords,acorporateboardin

whichmostmembers

havesimilarbackgroundsmayfallvictimtowhatisknownasgroupthink;theymaytrytominimizeconflictandreachconsensuswithoutcritically

analyzingandevaluatingideas.

WhatIsWrongwithCompensation

throughStockOptions?

Tomotivateseniorexecutives,manycompaniesawardstockoptions

totopmanagersandCEOs.Aboutstockoptions,Buffetthaswrit-

ten,“Thoughoptions,ifproperlystructured,canbeanappropriate,

andevenideal,waytocompensateandmotivatetopmanagers,theyare

moreoftenwildlycapriciousintheirdistributionsofrewards,inefficientE1C29

Date:Jan19,2010

Time:9:9am

CorporateGovernance:Employees,Directors,and

asmotivators,andinordinatelyexpensiveforshareholders.”8Ifthestockpriceincreasesafterstockoptionsareawarded,thevalueofstockoptionsalsoincreases.Inmostcases,thepotentialbenefitstotheexecutivesarehuge.ItisnotuncommonforsomeCEOsto

reapmillionsorevenhundredsofmillionsofdollarsthroughstockoptions.However,whenthe

stockpricedeclines,theexecutivesdonotsuffermuchbywayofdirect

monetarylosses.Fromtheshareholders’pointofview,thisisjustnot

fair.Buffettbelievesthat

executivesshouldparticipateinboththeupsideandthedownsideofstockpricemovements,justastheshareholdersdo.9

Forthisreason,executivesshouldbeencouragedtoownsharesinthe

company.

WhenGeneralRe,alargereinsurancecompany,was

acquiredby

BerkshireHathaway,BuffettchangedGeneralRe’scompensationplan.

Inaspecialmeetingofshareholdersheldtovoteonthemerger,which

Iattended,Buffettstatedthathepreferredtochangethecurrentplan

atGeneralRe,eventhoughitwouldcostaboutabilliondollarsto

immediatelyvestthesubstantialbenefitsunderexistingplans.

Inevaluatingacompany’sprospects,aninvestorshouldlookinto

executivecompensationplans.Greedyexecutives

preferstockoptions

overotherformsofpayments.Giventheincentivestructurearisingfrom

theexistenceofstockoptions,managersaremorelikelytocarefortheirowninterests,potentiallyatsubstantialcosttotheshareholders.They

alsotendtocaremoreabouttheshortrunratherthanthelongrun;as

stockoptionsgenerallyhavealimitedtimetomaturity.

CEOsoftenabusethestock-optioncompensationsystem.David

Yermack,aprofessoroffinanceatNewYorkUniversity,findsthatthe

timingofstockoptionsfrequentlycoincideswithmovementsinacom-

pany’sstockprices.10Attheendof2007,165companieswereunder

investigationinawide-rangingfederalprobeofstock-optiongrantsand

practices.ItappearsthatCEOsfrequentlyreceive

stock-optionawards

shortlybeforefavorablecorporatenews.Thus,CEOsbenefit,butatthe

expenseofshareholders.Evidencealsosuggeststhatmanagers,generally

speaking,announcebadnewspriortooptiongrantdatesandgoodnews

after.11

Forexample,CendantCorporation’sstockpricedeclineddramat-

icallyduring1998formanyreasons,includinganaccountingscandal.

WhenCendant’sstockpricedropped,alargeportionofCEOHenry

Date:Jan19,2010

Time:9:9am

corporategovernance

Silverman’s25.8millionstockoptions,originallypricedbetween$17

and$31ashare,wererepricedto$9.81—wellunderthethen-current

Cendantstockpriceof$15pershare.Silvermanearned$63.9millionin

1998andhadabout$400millioninthepipeline.Itdidnotmattertohim

thatthestockpricedeclined.And,ofcourse,hewould

haveearneda

largesumifthestockpricehadgoneup.Wow!HeadsIwin,tailsyoulose.

Notonlydidshareholderssufferbecauseofthepricedecline;theysuf-

feredevenmorewhenthecompany’sexecutiveswerehandsomelypaid.

HowtoIdentifyGoodCEOsorOther

SeniorManagers

AtBerkshireannualmeetings,WarrenBuffettsometimesmentionsthat

hewouldforgoaprofitableopportunityifpursuingitmeantforginga

partnershipwithsomeone

whomhedidnottrust.Inotherwords,ifyou

aresuspiciousoftheCEO,youshouldnotinvestinthatcompany’sstock.

Wheninvestingforthelongrun,thequalityofmanagement—including

integrity—ismoreimportantthancurrentprofitability,becauseprof-

itabilitycan’tbesustainedifmanagementqualityispoor.HereareafewsignsofagoodCEO,basedonBuffett’sthoughts.

Firstandforemost,trackrecordmattersalot.Tothebestofmy

knowledge,allBerkshiresubsidiaryCEOshaveaproventrackrecordin

theirrespectivecompaniesorinthesameindustry.Buffettisunlikelytohireapersonfromoneindustrytorunacompanyinanotherindustry.

Thiscoincideswithhisprincipleofstayinginyourcircleofcompetence.

MaybethiswasonereasonwhyRobertNardelliwasnotsuccessfulat

HomeDepot.In2000,hebecameCEOofHomeDepotaftersuc-

cessfullyrunningGeneralElectric’sminesandlocomotivebusinesses,

butNardellilackedretailexperience.In2007,hewasaskedtoresign

fromHomeDepot—onlytobeappointedastheChrysler

CEOseveral

monthslater!In2009,whenChryslerfiledforbankruptcy,heagreedto

resignfromhispositionbytheendofthebankruptcycase.

Second,CEOcompensationshouldbeexaminedforabuse.Noth-

ingiswrongwithpayingCEOswell,buttopaythemexorbitantlymay

indicatealaxcorporategovernanceculture.AtHomeDepot,Nardelli’s

problemsprobablystartedwiththefactthathewasfromadifferent

Date:Jan19,2010

Time:9:9am

CorporateGovernance:Employees,Directors,andCEOs

industrybutthathehadalsonegotiatedagenerouscompensationcon-

tract.Hehadaccesstoseveralcorporatejetsandotherexpensivebenefits,forwhichhewascriticized.Nardelli’scompensationwassowelldesigned

thatwhenheleftHomeDepot,hereceiveda$210millionseverance

package,despitepresidingovera40percentdeclineinthecompany’s

stockprice.HighlypaidCEOsalsocreateamoney-mindedculturein

theorganization.SuchCEOsdonotcommandrespectfromemploy-

ees,andwhencompaniesfallonhardtimes,theycannotpossiblylead

effectively.Suchorganizationsarenotlikely

todowellforshareholdersinthelongrun.

Third,aCEOshouldhaveaconceptualframeworkthatheorshecan

articulatewell.YoushouldlistencarefullytoaCEO’sanswersatpublic

meetingsorconferencecalls(allanalystconferencecallsarenowopen

tothepublic).Forexample,ifaCEOexpandsthecompanyintoanew

businessinwhichheorshelacksexpertise,howdoesheorsheexplain

thisdecision?Youshouldexaminetheexplanationcarefully.Buffettalso

paysattentionwhenCEOsforecastearnings:“Weare

suspiciousofthose

CEOswhoregularlyclaimtheydoknowthefuture—andwebecome

downrightincredulousiftheyconsistentlyreachtheirdeclaredtargets.

Managersthatalwayspromiseto‘makethenumbers’willatsomepoint

betemptedtomakeupthenumbers.”12Itmaynotbepossibletoavoid

allcompaniesthatmakeforecasts,becausemostdo.Butavoidinvesting

incompaniesforwhichCEOsclaimtoregularlyaccomplishseemingly

impossibletargets.

Fourth,youshouldreadthecompanychairman’sannualletters(fre-

quentlyco-signedbytheCEO)totheshareholdersfromseveralyears.

Iflettersgenerallyofferexcusesforweakresults,youshouldcertainly

besuspiciousofthequalityofthemanagement.Inmany

oftheselet-

ters,successisoftenattributedtomanagementefforts,butfailuresare

attributedtoexogenousreasons,suchastheweatherorChina’sproduct

dumping.Doyouwanttopartnerwithcompanymanagerswhohavea

habitofmakingexcusesandavoidingresponsibility?

Fifth,youshouldattendannualshareholdermeetings.Itgivesyoua

uniqueopportunitytoevaluatethecompany’smanagersbyexamining

theirresponsestoshareholderquestions.13Youmaynotlearnmoreabout

companyfinancialsastheyarealreadyreflectedincompanyfinancials.

However,yourobjectiveshouldbetolearnmoreaboutmanagement

Date:Jan19,2010

Time:9:9am

corporategovernance

attitudetowardshareholders,whichyoucertainlydointhesemeetings.

Youcandevelopasenseofwhetheryoutrustthemanagementornot.

BuffettandMungerhave

oftenemphasizedtheimportanceoftrustand

havementionedthattheywouldnotinvestinacompanyiftheydidnot

trustitsmanagement.Toshowhistrustinvariouscompanymanage-

ments,BuffetttransferredhisvotingrightsatdifferentpointsintimeinAmerican

Express,WashingtonPost,andSalomonInc.totheirrespectivemanagement.

Lastandprobablyoverarching,averyhighlevelofintegrityamong

companyemployeesandtheCEOisimportant.WhenBillGateswas

askedwhatheadmiredmostaboutWarrenBuffett,he

replied,“With

Warren,therearealotofthingsyoucouldpick,...hisintegrityis

anexamplefortheworld.”14AtvariousBerkshireannualshareholder

meetings,avideoclipofBuffett’s1991testimonytoCongressisshown

totheshareholderstoexplainthecompanyphilosophy.Atthetime,

BuffettwaschairmanoftheinvestmentbankingfirmSalomon,Inc.He

toldCongressthataletterwassenttoallSalomonemployeestoobey

alllawsandtobehaveasiftheywereneverashamedof

theiractions.

Buffettwrotetotheemployees,“LosemoneyforthefirmandIwill

beunderstanding;LoseashredofreputationforthefirmandIwillbe

ruthless.”15Clearly,moneyisimportantbutmoneyalonemustnotbe

themaindrivingforceforaCEO.Integrityismoreimportantforthe

long-termsurvivalofacompany.

Withsomethought,youshouldbeabletojudgethequalityand

integrityofacompany’sCEO.Thesesixpointsdonotbyanymeans

constituteanexhaustivelisttostudycompanymanagement.Forexam-

ple,IwouldratherinvestwithCEOswhodonotleadanextravagant

lifestyle.Iamnotclaimingthatidentifyingshareowner-orientedCEOs,

likeWarrenBuffett,iseasy.However,aninvestorshould

makesincere

effortsinthatdirection.Afterall,youonlyneedtofindafewoutstandingCEOstobesuccessfulinvestor.Itisindeedworththetrouble.

Conclusions

Asaninvestor,youshouldlookforcompaniesinwhichCEOsowna

significantinterestinthecompany’sstockanddonotreceiveexcessive

Date:Jan19,2010

Time:9:9am

CorporateGovernance:Employees,Directors,andCEOs

compensationfromthecompany,especiallythroughstockoptions.If

thetopmanagementisowner-oriented,fairlycompensated,andhas

well-thought-outincentiveplans,theconsequencesarelikelytobetrans-

mitteddowntheranks.Allemployeesarethenmotivatedtoworkhard,

andthecompanywillprobablyproduceextraordinaryresults,justas

Berkshiredoes.

Date:Jan19,2010

Time:9:9am

Date:Jan20,2010

Time:1:28pm

Chapter30

LargeShareholders:

TheyAreYourFriends

WarrenBuffettowns26.91%

ofthesharesinBerkshireHathaway.

—BerkshireHathawayProxyStatement,2009

WarrenBuffettisthelargestBerkshireHathawayshareholder

andeffectivelycontrolsthecompany.Similarly,Wal-Mart

iscontrolledbytheWaltonfamily,CharlesSchwabInc.

controlledbyCharlesSchwab,AmericaOnline(AOL)wascontrolledby

SteveCaseforalongtime,StarbucksiscontrolledbyHowardSchultz,

Amazon.comiscontrolledbyJeffreyBezos,OracleiscontrolledbyLarry

Ellison,andDelliscontrolledbyMichaelDell.Allthesecompanies

performedverywellfor10to20yearsorlonger.

FounderControlMatters

Whileyoumayhavemissedjoiningthesuccessfulentrepreneursjust

listed,plentyofothersare

likelytocometoyourattentionifyoukeep

lookingforthem.Asaninvestor,youshouldinvestigatefamily-controlledorindividuallycontrolledcompaniesforpotentialinvestment—theyare

usuallywell-managedandfriendlytoshareholders,especiallywhenthe

foundingCEOisstillincharge.Inawell-knownstudy,RonAnderson

Date:Jan20,2010

Time:1:28pm

corporategovernance

ofAmericanUniversityandDavidReebofTempleUniversityshow

that,amongallfirmsintheS&P500,familyfirmsperformbetterthannonfamilyfirms.1AdditionalresearchshowsthatwhenthefounderCEO

isincharge,performanceisevenbetter.Whymightthisbethecase?

AlthoughBuffettdidnotestablishBerkshireHathaway,hehasbeen

adirectorsince1965anditschairmanoftheboardsince1970,andso,

forallpracticalpurposes,heisthefounder.AsCEO,he

hasworkedhard

andmadealotofmoneyforBerkshire’sshareholders.Foraninvestor,

itisclearlyimportanttoconsiderwhetherthefirmwillcontinueto

dowellaftertheinitialsuccessunderafoundingCEO.Sincelong-term

successfulentrepreneursorfoundersareproudoftheiraccomplishments,

theyhaveastrongdesireforthefirmtocontinuetoperformwell.Itis

personalforthem.Justasmostpeoplewouldliketheirfamiliestobe

successful,theiruniversitiestobecomeprominent,and

theirchildrento

bethebesttheycanbe,thefounderofacompanywouldlikealongand

successfullifeforthefirm.

Apassionatemanagerorbusinessownerdoesnotbecomesatisfied

simplybecauseagoalisreached.Eachsuccesspaves

thewayforachievingbiggergoals.Asuccessfulhighschoolfootballcoachwantstobecomea

collegecoach,andsoon.Thus,youaretypicallyingoodhandswhen

youinvestwithsuccessfulentrepreneurs,evenifyouinvestwiththem

aftersomesuccesshas

alreadybeenreflectedinthestockprice.Ifyou

hadinvestedinWal-Martin1982,bywhichtimeithadbeenlistedfor

10yearsontheNewYorkStockExchange,youwouldhaveearned

phenomenalreturns—morethan1,000percentoverthenext10years.

Ofcourse,youshoulddoyourcompany-specificanalysisnomatterwhen

youinvest.

Duringthesecond,third,orfourthgeneration,afamily-controlled

companymaynotbeassuccessfulasitwasundertheoriginal

entrepreneur.MotorolaandHewlett-Packard,nowmorethantwo

generationsold,havefacedintermittenttroubles.Whilebotharestill

world-classcompanies,theirrecentperformanceshavenotequaledtheir

earlyperformances.Similarly,HenryFord’sand

E.I.DuPont’slegacies

ofentrepreneurshiphavenotbeenduplicated,eventhoughthefamilies

continuetomaintainsubstantialinterestinthesecompanies.Thus,asan

investor,youshouldinvestigatethecompanymorethoroughlywhenthe

foundingCEOisnolongerinfluential.

Date:Jan20,2010

Time:1:28pm

LargeShareholders:TheyAreYourFriends

IntheS&P500universe,manycompaniesarerunbytheirfounders.

AndersonandReebfoundthatfoundingfamiliesareinvolvedinabout

one-thirdoftheS&P500firmsandownabout18percentoftheout-

standingequityofthesecompanies.Keepinmind

thatthestockprices

ofthesecompaniesfluctuategreatly;theyarebidupveryhighinsome

yearsandpusheddownsubstantiallyinotheryears.Inpart,thishap-

pensbecauseowner-managersdonotpayasmuchattentiontothestock

pricesashiredmanagersdo.Butbythesamelogic,owner-managersare

alsonotlikelytoengageinearningsmanagementtomanipulatestock

prices.Overall,withotherfactorsheldconstant,youareunlikelytogo

wrongifyouinvestincompaniesrunbytheir

founders.

Acontrollinginterestisimportanttoanowner-orientedmanager

becauseheorshecannotbeinfluencedbycorporateraidersincasethe

stockpricegoesdown.Instead,heorshecanremainfocusedonthe

longrun.Ifso,acontrollinginterestinthehandsofoneorafewis

beneficialtoallshareholders.2Acontrollinginterestisoftenmaintainedbyadual-classstockstructureinwhichoneclassofshareshasahigher

votingpowerperunitofeconomicorcashflowrights.InBerkshire’s

case,classAstockhas30timestheeconomicinterestpershareofclass

Bstockbuthas200timesthevotingpower.Berkshirehasannounceda

50:1stocksplitforitsclassBshareseffectivefromayet-to-be-announceddatein2010.ClassAshareswillnotbesplit.BecauseWarrenBuffett

andCharlieMungertogethereffectivelyhaveacontrollinginterestin

thecompany,theydonotworryaboutanunfriendlytakeover.

GoogleInc.alsohasadual-classcommonstockstructure.CEOEric

Schmidt,SergeyBrin,andLarryPagetogetherhold

about22percent

oftheshares,buttheycontrolabout66percentofthevotingpower.

In2004,whenGooglewentpublicwithadual-classstructure,several

articlesinthepopularpresscriticizedthecompany.Investorswouldhaveearnedseveralhundredpercent

returnsinafewyearsiftheyhadignored

thecriticismandinvestedinGoogle’sstock.

Conclusions

Largeshareholdersinacompanyarelikelytomonitorthecompany’s

managementinawaythatisnotpossiblewhenthe

shareholdingis

Date:Jan20,2010

Time:1:28pm

corporategovernance

moredispersed.Similarly,

CEOswithlargeshareholdingsarelikelytobe

shareholderfriendly.UnlessWarrenBuffettdecidestorunforapoliticaloffice,yourmoneyisgenerallysaferinhishands,orinthehandsofotherentrepreneur-owner-managers,thanwiththehiredmanagerswhorun

thevastmajorityofothercompanies.

E1BOTH

Date:Jan19,2010

Time:9:28am

Conclusion

B=Baseball=Buffett

WarrenBuffettfrequentlyusessportsanalogiestoexplain

thegameofinvesting.Inthisconclusion,IfollowBuffett’s

refreshingsimilebetweensportsandinvestingtoexplain

thekeyfeaturesforsuccessininvesting.Intheappendixthatfollowsthischapter,Ipresentashortsummaryofthebook.

Whenweplaybaseball—or,really,anysport—whatmotivatesus?

Whataboutwhenweplaybridge?Whatmotivatesusthen?Istherea

singlemostimportantprinciplethatmakesusbetteratanygame,includ-

ingthegameofinvesting?IfIhavetopointtoasinglecharacteristic,Iwouldsaythatthesurvivalinstinct,whichhasbeenthoroughlyexplained

inTheSelfishGeneandearlierinTheOriginofSpecies,leadsplayerstovictorymorethananythingelse.1Thesurvivalinstinctcanbethoughtof

asthemind-settowin.Onceweseeagamewiththiswinningmind-set,

therestofourbehaviorfollowsnaturallytoputusinthebestpossible

positiontoemergevictorious.

Don’tLoseMoney

Themind-settowinistheoverarchingprinciplethatappliestolife,

sports,andinvesting.Otherrulesaregenerallyderivativesofthisfundamentalnotion.Let’sstartwithbaseball.Everyone

hasbeentold,“Keep

youreyesontheball.”Ifyourobjectiveistowinthegameandyouhave

E1BOTH

Date:Jan19,2010

Time:9:28am

conclusion

completelyinternalizedtheideathatyouwanttowin,thenyourmind

shutsoutotherthoughts,andyouseetheballasclearlyaspossible.Youautomaticallykeepyoureyesontheball.Yourbodynaturallyreactsin

acoordinatedmotionthatmaysurpriseyou.Thisisbecauseyouhave

developedamind-settowin.Furthermore,supposeyouloseagameby

hittingaflyballthatiscaughtjustshortofthefence,andyourealizethatyoulostbecauseyoulackedthephysicalstrengthtodrivetheballoutofthepark.Ifyou

haveinternalizedthefundamentalprinciple,youwillbe

motivatedtogotothegymandaddthenecessarymuscle.

Let’sapplythesameideastowinninginthestockmarket.Sincethe

stockmarketisallaboutmoney,youwinbyearning

goodreturnson

yourinvestments.Attheveryleast,youdon’twanttolosethemoney

youoriginallyinvested,theprincipal.Buffettputsitslightlydifferently,butthephilosophyisthesame.Hesays,“Rulenumber1:Don’tlose

money.”2

Thinkingintermsofnotlosingandwinningatthesametimegivesrisetomostoftheideasthathavebeendiscussedinthisbook.Whenyouplan

toinvest,youshouldlookatBuffett’sruleonnotlosingmoneyandask

thequestion,“WhatarethechancesthatIwilllosemoney?”Bytryingto

decidetheprobabilityoflosing,youareautomaticallybeginningtothinkintermsofvalueinvesting,ataverybasiclevel.Ifyoufindthatyouarestilllosingbecauseyoudon’tknowenoughaboutvalueinvesting,youwill

bemotivatedtolearnmore.Later,towinbigorearnveryhighreturns,

youwillstarttotakeaharder

lookatthegrowthpotentialofcompanies

andeventuallygrasptheprinciplesofgrowthinvesting.Atthispoint,byfollowingthetwoprinciplesofbeingcarefulnottoloseandtryingto

win,youwilllearntocombinevalueinvestingwithgrowthinvestingas

Ihavediscussedinthisbook.ThisiswhatIcallBuffettinvesting.

Onceyoudevelopthemind-settowin,yoursubconsciouswillguide

youtootherrulesforyoursuccess.Youmayindeedproducesuper-

sizereturnsjustasWarrenBuffetthas.Buffettdoesnot

simplypractice

valueplusgrowthinvestingbuthasalargerepertoire.Heparticipatesinthemarketthroughjudicioususeoffinancialproductssuchasoptions,

futures,andswaps.Healsomanagesoneofthelargestcompaniesin

theworldwithoperationsin

theinsurance,retail,manufacturing,util-

ities,andfinancialservicessectors.Hehasdevelopedapsychological

bentthatallowshimtolookatmarketmovementsobjectively.Forall

E1BOTH

Date:Jan19,2010

Time:9:28am

Conclusion

thesereasons,Icallhimarenaissanceinvestor.Perhapsthatshouldbe

yourfinalgoal:tobecomearenaissanceinvestor.Thegoodthingisthat

winninginthegameofinvestingdoesnotrequireahighIQormagical

mantras.Overall,onceyoudecideyouwanttosucceed,youwill.

StayinYourCircleofCompetence

Inthecontextofmind-settowin,onequestionhasalwaysappealedto

me:“HowdoyoubeatworldchesschampionBobbyFischer?”3Yes,it

isabitofatrickquestion.IfyouwanttobeatBobbyFischer,youdon’tplaychesswithhim.Youfindagamethatyoucanwin.Pickingupthe

baseballanalogy,assumethatdespiteallyourefforts,youstillcan’thit.

Thenyouareplayingthewronggame.Youshouldfindanewgame,a

gamethatyoucanwin.Ifyouaretall,maybeyoushouldtrybasketball;

ifyouhavegoodendurance,maybeyoushouldrunamarathon.

Findingtherightgameisextremelyrelevantto

investing.Ifthehigh-

techindustryisnotwhereyoucanwin,thendon’tinvestinit.Buffett

doesnotinvestinhigh-tech.Findanindustrywhereyoucanwin,and

investthere.Ifyoucan’tfigureouthowacompanywillprobablyshape

upin10years,don’tinvestinit;findacompanythatyouunderstandso

youcanprojectitslikelyfuture.Youdon’thavetoplayeverysport,andyoudon’thavetohaveanopiniononeverystock.Inotherwords,the

fundamentalprinciplewillkeepyouinsideyourcircleofcompetence,an

investingrulethatBuffetthasoftendiscussed.InthebookletBatting,BabeRuthwroteasimpleruleforwinninginbaseball:“Learnnottoswing

atbadballs.”Similarly,youshouldinvestonlywhenyouunderstandthe

companyandonlywhenthemarketpriceisfavorableinrelationtothe

stock’sintrinsicvalue.Itisimportanttobepatient.Youwaitandwaitandwaitforafatpitchoragoodstock,andwhenitcomes,youswingaway.

FindGoodPeople

Insports,managersmakekeydecisions,suchaswhichprospectstodraft

andwhichcoachestohire.

Effectively,high-qualitymanagementisa

prerequisitetosuccess—asMichaelLewisshowsinhisstoryofthegen-

eralmanagerBillyBeaneandhishighlysuccessfulbaseballteamOakland

E1BOTH

Date:Jan19,2010

Time:9:28am

conclusion

A’s,despitelimitedfinancialresourcesinMoneyball.4Thesameistrueininvesting.Buffetthasemphasizedtheimportanceofmanagementcompetenceandintegrityaboveothermetricsinexplaininghissuccess.If

youwanttowininthegameofinvesting,youshouldlookformanagers

whohaveproventobeoutstandingatrunningcompanies.Berkshire

HathawayisonesuchcompanyIfound.Whenyoufindoutstanding

peoplelikeBuffett,buysharesintheircompanies.If

theyheadupmoney

managementfirms,investwiththem.Goodluck!

E1BAPP

Date:Jan19,2010

Time:9:36am

Appendix

ASummaryoftheBook

WarrenBuffettisageniusinthesameleagueasBenjamin

Franklin,ErnestHemingway,andHenryFord.Theirideas

aresimpletounderstand,buttheirsuccessesaredifficult

toduplicate.However,geniusesabidebycertainprinciplesthatwecan

learnfrom.Inthisbook,IhavetriedtoexplaintheprinciplesthatI

believeBuffettfollows.Thisappendixprovidesasuccinctsummary.

TableA.1

SummaryofWarrenBuffett’sInvestmentPrinciples

Principle

Explanation

(i)DevelopaMind-SettoWin

Youplayagamebecauseit’s

funandeven

exhilaratingwhenyouwin.Youwillwin

oftenwhenyouplaytoyourstrengths.In

thestockmarketgame,thismeansstaying

withinyourcircleofcompetence.

(ii)StickwithValueInvesting

Examinehistoricalrecords,price-to-

earningsratios(P/E),andotherfinancial

measures.

(iii)CombineGrowthInvesting

Managementwithintegrityand

withValueInvesting

competenceisthekeytogrowth.Make

surethequalityofacompany’s

managementisoutstanding.

(continued)

E1BAPP

Date:Jan19,2010

Time:9:36am

appendix

TableA.1

Continued

Principle

Explanation

(iv)MaintainLowRisk

Lowdebtlevel.Reread(ii).Learnsome

accountingtolookforpossiblehidden

risks.

(v)ActRationally

Knowledgeisthebestantidoteto

irrationality.Knowthecompany’s

business,andprojectwhatthecompany

willlooklikein10years.

(vi)DoNotPayaHighPrice

Estimateacompany’sintrinsicvalueby

learningaboutthecompany’sbusiness.

Investonlywhenthepriceislow

comparedwiththeintrinsicvalue.

(vii)FindGoodPeople

Trytofindandinvestwithoutstanding

peoplelikeWarrenBuffett;theytreatthe

shareholders’interestsastheirown.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

Preface

1.WarrenE.Buffett,“UptheInefficientMarket,”Barron’s(February25,1985),11.

2.“Billionaires2008,”Forbes(March24,2008),80.

3.BerkshireHathawayAnnualReport1996,16.

4.ThereareatleasttwoexcellentBuffettbiographies:RogerLowenstein,Buffett:TheMakingofanAmericanCapitalist(NewYork:RandomHouseTradePaperbacks,2008),andAliceSchroeder,TheSnowball:WarrenBuffettandtheBusinessofLife(NewYork:BantamBooks,2008).

Chapter1TheThrillof

InvestinginCommonStocks

1.RogerLowenstein,Buffett:TheMakingofanAmericanCapitalist,20.

2.“Mr.Market”isafictitiouscharactercreatedbyBenjaminGrahamtorepresentmarketindicesandhasoftenbeendiscussedbyWarrenBuffett.SeeBenjaminGraham,The

IntelligentInvestor(NewYork:HarperCollinsPublishers,1996,originallypublishedbyHarper&Rowin1973),108.

3.PeterLynchwithJohnRothchild,BeatingtheStreet(NewYork:SimonandSchuster,1993),20.

4.WarrenE.Buffett,“BuyAmerican,Iam.”NewYorkTimes(October17,2008,Op-

5.LaurenC.TempletonandScottPhilips,InvestingtheTempletonWay(NewYork:McGraw-Hill,2008),x.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

Chapter21965–2009:LessonsfromSignificantEventsinBerkshire

History

2.BerkshireHathaway

AnnualReport1984,12.

4.Ibid.,9.

6.BenjaminFranklin,AutobiographyofBenjaminFranklin(NewYork:SimonandSchuster,1993),28.

8.Ibid.

10.Ibid.,14.

11.Ibid.

13.Ibid.

16.Ibid.

18.BerkshireHathaway

20.Ibid.

22.Ibid.,6.

23.Ibid.,10.

24.Ibid.,6.

25.Ibid.

27.Ibid.

Chapter3ValueInvesting—It’sLikeBuyingChristmasCardsinJanuary

2.BenjaminGraham,TheIntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedbyHarper&Rowin1973),54.

3.Ibid.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

4.DataareobtainedfromProfessorRobertShiller’sWebsiteatYaleUniversity.

Thesedataareupdatedfrequently.

5.JohnNeff,JohnNeffon

Investing,withS.L.Mintz(NewYork:JohnWiley&Sons,1999),122.

8.Ibid.,280.

9.WarrenBuffett,“TheSuperinvestorsofGraham-

and-Doddsville,”inGraham,1973,appendix.

10.Graham,82.

11.JosefLakonishok,AndreiShleifer,andRobertW.Vishny,“Contrarian

Investment,Extrapolation,andRisk,”JournalofFinance(1994):1541–

12.BenjaminGrahamdiscussesglamour-typestocksinTheIntelligentInvestoronpage182.Hepointsoutthatintheshortrun,glamourstocksmaydowellandcommon-stockinvestmentpolicymustdependontheindividualinvestor.

13.EugeneFamaandKennethFrench,“TheCross-sectionofExpectedStock

Returns,”JournalofFinance(1992):427–466.

14.DavidDreman,ContrarianInvestmentStrategies:TheNextGeneration(NewYork:SimonandSchuster,1998).

15.Ibid.,61.

16.Forthisanalysis,thevalueportfolioiscomposedofthestocksinthetwo

deciles(i.e.,about20percentofthetotalnumberofstocks)withthesmallestmarket-to-bookratio,whiletheglamourportfolioiscomposedofthecorrespondinglargestmarket-to-bookratiostocks.

17.LouisK.C.ChanandJosefLakonishok,“ValueandGrowthInvesting:ReviewandUpdate,”FinancialAnalystsJournal(2004):71-86.

Chapter4GrowthInvesting

1.PhilipA.Fisher,CommonStocksandUncommonProfits(NewYork:JohnWiley

&Sons,1996),15.

2.BenjaminGraham,TheIntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedby

Harper&Rowin1973),57.

3.Wal-Mart’sWebsite,www.walmart.com.

4.JayR.RitterandIvoWelch,“AReviewofIPOActivity,Pricing,andAllocations,”JournalofFinance(2002):1795–1828.Forresultsonrecentyears,seeupdatesbyJayRitterattheUniversityofFloridaWebsite.

5.SamWalton,MadeinAmerica,withJohnHuey(NewYork:BantamBooks,1993).

6.MichaelDell,DirectfromDell:StrategiesThatRevolutionalizedanIndustry,withCatherineFreidman(NewYork:HarperCollins,1999).

E1BNOTES

Date:Jan20,2010

Time:3:35pm

7.ClaytonM.Christensen,TheInnovator’sDilemma:WhenNewTechnologiesCauseGreatFirmstoFail(Boston:HarvardBusinessSchoolPress,1997).

8.Fisher,35.

Chapter5IntrinsicValue

1.BenjaminGrahamandDavidDodd,SecurityAnalysis(NewYork:McGraw-Hill,1934),17.

3.WescoFinancialCorporationAnnualReport

2008,7.

4.MyronJ.Gordon,TheInvestmentFinancingandValuationoftheCorporation(Homewood,IL:RichardD.Irwin,1962).

6.Theassumptionofagrowthratesmallerthanthediscountrateimpliesthat

Berkshiremaysellsomesharestoinvestinwhollyownedsubsidiariesthatgenerateearningsorthatthestockmarketgrowthrateinthecoming10yearswillbeabout5.5percentplusdividends.

Chapter6BuffettInvesting=Value+Growth

2.GeraldS.MartinandJohnPuthenpurackal,“ImitationIstheSincerestFormofFlattery:WarrenBuffettandBerkshireHathaway,”AmericanUniversity

workingpaper,April2009.

3.Buffett’slettertohispartnersinBuffettPartnership,October9,1967.

4.BerkshireHathaway

AnnualReport2008,7.

5.ColumbiaUniversity,“WarrenEdwardBuffett,”http://c250.columbia.edu/

c250celebrates/remarkablecolumbians/warrenedwardbuffett.html.

7.BerkshireHathaway

11.In1999,thepretaxoperatingprofitsof$225milliononrevenuesrepresent

a12percentmarginonrevenuesanda12.5percentreturnonidentifiableassets.

Thiscertainlyseemssatisfactory.

12.FortunepublishedacoverstoryonBYD,“Buffett’sElectricCar,”April27,2009,pp.44–60.

13.CharlieMungerhashadaconsiderableinfluenceon

Buffett,especiallyinthinkingaboutgrowthinvesting.Mungerwasalsothemainpersoninconvincing

BuffetttoinvestinBYD.Thus,thisstyleofcombiningvalueinvestingwithgrowthinvestingmayalsobecalledBuffett-Mungerinvesting.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

Chapter7Insurance:OtherPeople’sMoney

6.CharlieMunger,“LetterfromtheChairmanandthe

PresidentofBlueChipStamps,1981,”inBerkshireHathawayAnnualReport1981,47.

7.CharlieMunger,“LetterfromtheChairmanandthePresidentofBlueChipStamps,1982,”inBerkshireHathawayAnnualReport1982,59.

Chapter8Reinsurance:MoreofOtherPeople’s

2.Ibid.,10.

4.Ibid.,9.

Chapter9TaxDeferment:Interest-FreeLoansfromtheGovernment

1.WescoFinancialCorporationAnnualReport2000,6.

Chapter10IfYouDon’tKnowJewelry,KnowYourJeweler

4.BerkshireHathaway

AnnualReport1995,7.

5.BarnettC.Helzberg,WhatILearnedbeforeISoldtoWarrenBuffett(Hoboken,NJ:JohnWiley&Sons,1993),xx.

6.Ibid.,xvii.

Chapter11CompeteLikeMrs.B

1.BerkshireHathaway

3.ThisMrs.BquoteisfromNebraskaFurnitureMart’swebsite,www.nfm.com/

ourstoryhistory.aspx?ID=1a.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

5.PeterLynchwithJohnRothchild,OneUponWallStreet(NewYork:PenguinBooks,1989),123.

7.Ibid.,9.

10.WescoFinancialCorporationAnnualReport2008,14.

Chapter12WhyInvestinUtilityCompanies?

2.MidAmericanEnergypressrelease,October25,1999.

3.Ibid.

5.AMidAmericansubsidiary,HomeServices(previouslyHomeServices.com),isacollectionofmanysmalllocalrealestatefirmsandhasgrownsteadily.Interestingly,itsphilosophyofkeepingtheindividualunitsindependentissimilartoBerkshire’smodelforitssubsidiaries.IownedsharesinHomeServices.combeforeitwasacquired.

6.Imadesomeadjustmentstothereportedaccountingnumbersforthemtobecomparableacrossyears.Forexample,IdonotincludegainsfrominvestmentinConstellationEnergyandthebreak-upfeeasexplainedintheBerkshireHathaway2008annualreport.

Chapter13HighProfitsinHonest-to-Goodness

ManufacturingCompanies

2.SinceShawIndustrieswasacquiredafterthebeginningof2001,someofthenumbersfortheyear2001inthetablehavebeenadjustedslightlytomakethemcomparablefortheotherfull-yearnumbers.

3.TribuneBusinessNews,

July21,2006.

4.LorraineD.Miller,“ScoringtheBoardCompanyProfile,”Flooring(August1,1977).

Chapter14RiskandVolatility:HowtoThinkProfitably

aboutThem

1.BerkshireHathaway

2.SeethepreviouslymentionedarticleinChapter3byEugeneFamaand

KennethFrench(1992)andadditionalinsightbyS.P.Kothari,JayShanken,andRichardSloan,“AnotherLookattheCross-SectionofExpectedReturns,”

JournalofFinance(1995):

185–224.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

3.TheOrangeCountyexampleisnotunique.In

March2008,JeffersonCounty,Alabama,failedtoproduce$200millionincollateralforitsswaps.SeeWallStreetJournalonlineedition,March22,2008.

4.BerkshireHathawayAnnualReport(10-K)1999,18.

6.RobertJ.Shiller,MarketVolatility(Cambridge,MA:TheMITPress,1999).

7.Forbes,“TheMoneyMen,”November1,1974,pp.41-42.

10.Ibid.

Chapter15WhyHoldCash:LiquidityBringsOpportunities

2.MorganStanleyEquityResearchReportonInsurance-PropertyandCasualty,NewYork,WorldTradeCenterSpecialIssue,

September17,2001.

3.AsreportedinapressreleasebyWrigleyonApril28,2008,availableonWrigley.com.

Chapter16Diversification:HowManyBasketsShouldYouHold?

1.SeeChapter13inStephenA.Ross,RandolphW.Westerfield,andBradfordD.

Jordan,FundamentalsofCorporateFinance(NewYork:McGraw-HillIrwin,2006).Foradetailedacademicdiscussionofthistopic,seeEugeneFama,

FoundationsofFinance(NewYork:BasicBooks,1976).

2.ForthispurposeIassumedatypicalstocktohaveacovarianceof0.18withother

stocks.Thisistypicalofanexchangetradedstock.

3.BenjaminGraham,TheIntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedbyHarper&Rowin1973),54.

4.PhilipA.Fisher,CommonStocksandUncommonProfits(NewYork:JohnWiley

&Sons,1996),108.

6.Ibid.

7.Ibid.,150.

Chapter17WhentoSell

1.BerkshireHathaway

5.See,forexample,WashingtonPost,October31,2007.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

Chapter18HowEfficientIstheStockMarket?

1.BerkshireHathaway

2.SeeHemangDesaiandPremC.Jain,“AnAnalysisoftheRecommendations

ofthe‘Superstar’MoneyManagersatBarron’sAnnualRoundtable,”JournalofFinance(1995):1257–1273.Inthisarticle,weshowthateventhestockrecommendationspublishedinBarron’sbytheso-called

superstarmoneymanagersdonotproduceexcessreturns.

3.Forasummaryofthisresearch,seeAndreiShleifer,InefficientMarkets(OxfordUniversityPress,2000).

4.AndrewW.LoandA.CraigMacKinlay,“ANon-RandomWalkDownWall

Street”(Princeton,NJ:PrincetonUniversityPress,

2001).

5.Severalpapersinrecentyearstrytoexplaindeviationofpricesfromfundamentals.Forarecentpaper,seeHenkBerkman,ValentinDimitrov,PremC.Jain,PaulKoch,andSheriTice,“SellontheNews:DifferencesofOpinion,Short-SalesConstraints,andReturnsAroundEarningsAnnouncements,”Journalof

FinancialEconomics92(June2009):376–399.

6.See,forexample,HemangDesaiandPremC.Jain,“FirmPerformanceand

Focus:Long-runStockMarketPerformanceFollowingSpinoffs,”JournalofFinancialEconomics(October1999):75–101.AlsoseeHemangDesaiandPremC.Jain,“Long-Run

CommonStockReturnsfollowingStockSplits

andReverseSplits,”JournalofBusiness(1977):409-433.

7.NarasimhanJegadeeshandSheridanTitman,“Cross-SectionalandTime-

SeriesDeterminantsofMomentumReturns,”ReviewofFinancialStudies15

(2002):143–157.

8.WernerDeBondtandRichardThaler,“FurtherEvidenceonInvestorOverreactionandStockMarketSeasonality,”JournalofFinance42(July1987):557–581.

SeveralothersimilarpapersareexplainedinRichardThaler,AdvancesinBehavioralFinance,Volume

II(Princeton,NJ:PrincetonUniversityPress,2005).

9.LouisChan,NarasimhanJegadeesh,andJosefLakonishok,“MomentumStrategies,”JournalofFinance51(December1996):1681-1713.

Chapter19Arbitrageand

HedgeFunds

3.Foradetailedaccount,seeRogerLowenstein,WhenGeniusFailed:TheRiseandFallofLong-TermCapitalManagement(NewYork:RandomHouseTrade

Paperbacks,2001).

4.BurtonG.MalkielandAtanuSaha,“HedgeFunds:RiskandReturn,”FinancialAnalystsJournal(2005):80–88.

5.AndrewW.Lo,HedgeFunds:AnAnalyticPerspective(Princeton,NJ:PrincetonUniversityPress,2008).

E1BNOTES

Date:Jan20,2010

Time:3:35pm

6.LudovicPhalippouandOliverGottschalg,“ThePerformanceofPrivateEquityFunds,”Reviewof

FinancialStudies22(2009):1747-1776.

7.SteveKaplanandAntoinetteSchoar,“PrivateEquityPerformance:Returns,PersistenceandCapital,”JournalofFinance60(August2005):1791–1823.

Chapter20:M=Monopoly=Money

1.BerkshireHathaway

2.Whileitistemptingtocomparethetwocompaniesusingreturnonequity(ROE),IdonotdosobecausebothMicrosoftandIBMrepurchasedsignificantamountsofcommonstockinrecentyears.ThesetransactionsmadebookvaluesofequityverysmallandROEcomparisonsmeaningless.Thisalsoshows

thatmindlesscomparisonoffinancialratiosmaynotyieldusefulresults.

3.AninsightfulhistoryofBuffaloNewsispresentedbyMurrayB.LightinFromButlertoBuffett:TheStoryBehindtheBuffaloNews(PrometheusBooks,2004).

Intheforewordtothebook,BuffettdescribesMurrayLighttobeabril-

liantandtirelesseditorwhosuccessfullypulledoffaSundayeditionofthenewspaper.

Chapter21WhoWinsin

HighlyCompetitiveIndustries?

2.Buffettexplainedthispointinaquestion–answersessionatColumbiaUniversityonNovember12,2009.Hesaid,“TheBurlingtonNorthernlastyear

moved...atonoffreight

470milesononegallonofdiesel.Thatisfar,farmoreefficientthanwhattakesplaceoverthehighways.I’mwillingtobet...

onthefactthat10yearsfromnow,20yearsfromnow,50yearsfromnow,therewillbemoregoodsbeingmovedbyrailanditwillbebetterforthecountryandfortheshareholders.”Thetranscriptisavailableon

www.cnbc.com.

Chapter22Property,Plant,andEquipment:GoodorBad?

1.WescoFinancialCorporationannualmeeting,May9,2007.

2.NetPPEandtotalassetsas

ofSeptember28,1963,were$12.8millionand$39.5million,respectively.

Chapter23KeytoSuccess:ROEandOtherRatios

1.SeeBenjaminGraham,DavidL.Dodd,andSidneyCottle(4thed.),SecurityAnalysis(NewYork:

McGraw-Hill,1962),231.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

2.Ibid.,464.

3.Probablythemostwell-

knownaccountingresearchpaperthatinfluencedthewayhedgefundsinvestinlong-shortstrategiesisRichardG.Sloan’s“DoStockPricesFullyReflectInformationinAccrualsandCashFlowsaboutFuture

Earnings?”AccountingReview(1996):289–315.

5.WorldCom8-K,SecuritiesandExchangeCommission,Washington,DC,August8,2002.

Chapter24AccountingGoodwill:IsItAnyGood?

Chapter25HowMuchPsychologyShouldYouKnow?

1.L.J.Davis,“BuffettTakesStock,”NewYorkTimes,April1,1990.

3.BenjaminGraham,

IntelligentInvestor(4thed.)(NewYork:HarperCollins,originallypublishedbyHarper&Rowin1973),94.

4.GeorgeSoros,TheAlchemyofFinance(NewYork:JohnWiley&Sons,1987).

5.GeorgeA.AkerlofandRobertJ.Shiller,AnimalSpirits(Princeton,NJ:PrincetonUniversityPress,

2009).AlsoseeHershShefrin,BeyondGreedandFear(NewYork:OxfordUniversityPress,2002).

6.TerranceOdean,“AreInvestorsReluctanttoRealizeTheirLosses?”JournalofFinance53,no.5(October1998):1775–1798.

7.BradBarberandTerranceOdean,“TradingIsHazardoustoYourWealth:

TheCommonStockInvestmentPerformanceofIndividualInvestors,”JournalofFinance55,no.2(April2000):773–806.

8.PremC.JainandJoannaShuangWu,“TruthinMutualFundAdvertising:

EvidenceonFuturePerformanceandFundFlows,”JournalofFinance66,no.2

(April2000):937–958.

9.Forfurtherreadings,seeMichaelJ.Mauboussin,MoreThanYouKnow:FindingFinancialWisdominUnconventionalPlaces(NewYork,NY:ColumbiaBusinessSchoolPublishing,2008).CharlieMungerhasoftenconvincinglyarguedtheimportanceofpsychologyinhisdialoguesattheBerkshireandWescoannual

meetings.HehasalsorecommendedbooksbyRobertB.Cialdini.Ihave

benefitedfromhisrecommendationsandhistalks.SeveralofMunger’sverywell-articulatedtalksandthoughtsarepublishedinPoorCharlie’sAlmanack:TheWitandWisdomofCharlesT.Munger,editedbyPeterD.Kaufman(Marceline,MO:Walsworth

PublishingCompany,2008).

E1BNOTES

Date:Jan20,2010

Time:3:35pm

Chapter26HowtoLearnfromMistakes

1.BerkshireHathawayShareholders’annualmeeting,2005.

2.TomDowdell,SureshGovindaraj,andPremJain,“TheTylenolIncident,EnsuingRegulations,andStockPrices,”JournalofFinancialandQuantitativeAnalysis(1992):283–301.

3.MichaelJ.Mauboussin,ThinkTwice:Harnessingthe

PowerofCounterintuition(Boston,MA:HarvardBusinessPress,2009).

4.RichardH.ThalerandCassR.Sustein,Nudge:ImprovingDecisionsAboutHealth,WealthandHappiness(NewHaven,CT:YaleUniversityPress,2008).Theauthorsarguethatitissometimeshelpfultomakemistakes,sincethatishowwelearn.

Chapter27Dividends:DoTheyMakeSenseinThisDayandAge?

1.MertonMillerandFrancoModigliani,“DividendPolicy,Growth,andthe

ValuationofShares,”JournalofBusiness(1961):411–433.

2.FischerBlack,“TheDividendPuzzle,”Journalof

PortfolioManagement2(Winter1976):72–77.

Chapter28ShouldYouInvestinCompaniesThatRepurchaseTheir

OwnShares?

2.AmyK.Dittmar,“WhyDoFirmsRepurchaseStock?”

JournalofBusiness(2000):331–355.Forlong-runperformancefollowingrepurchases,seeDavidIkenberry,JosephLakonishok,andTheoVermaelen,“MarketUnderreaction

toOpenMarketShareRepurchases,”JournalofFinancialEconomics39(1995):181–208.

4.Ibid.,6.

5.Ibid.

7.Ibid.,17.

Chapter29CorporateGovernance:Employees,

Directors,andCEOs

2.Ibid.

4.PaulM.Healy,“TheEffectofBonusSchemesonAccountingDecisions,”

JournalofAccountingandEconomics(1985):85–107.

5.Ibid.

E1BNOTES

Date:Jan20,2010

Time:3:35pm

9.Academicresearchevidencealsodoesnotsuggestthatstockoptionsimprovecompanyprofitssignificantly.SeeDavid

Larcker,“DiscussionofAreExecutiveStockOptionsAssociatedwithFutureEarnings?”JournalofAccountingandEconomics36(2003):91–103.

10.DavidYermack,“GoodTiming:CEOOptionAwardsandCompanyNews

Announcements,”JournalofFinance(1977):449–476.

11.DavidAboodyandRonKasznik,“CEOStockOptionAwardsandtheTiming

ofCorporateVoluntaryDisclosures,”JournalofAccountingandEconomics29

(2000):73–100.

13.RandyCepuchdescribeshisexperiencesfromattendingalargenumberofannualshareholdermeetingsintheUnitedStates,Europe,andAustralia.SeeRandyCepuch,AWeekendwithWarrenBuffett:AndOtherShareholderMeetingAdventures(NewYork:BasicBooks,2007).Youshouldalsobeawarethatmanagersoftenannouncegoodnewspriortoorduringtheannual

shareholdermeetings.SeeValentinDimitrovandPremC.Jain,“It’sShowtime.DoManagersManipulateStockPricesbeforeAnnualShareholderMeetings?”

Workingpaper,McDonoughSchoolofBusiness,GeorgetownUniversity,

14.Aquestionandanswer

sessionwithstudentsatColumbiaUniversityon

November12,2009.

15.RogerLowenstein,Buffett:TheMakingofanAmericanCapitalist(NewYork:RandomHouseTradePaperbacks,2008),395.

Chapter30LargeShareholders:TheyAreYourFriends

1.RonaldC.AndersonandDavidM.Reeb,“Founding-FamilyOwnershipand

FirmPerformance:EvidencefromtheS&P500,”JournalofFinance(June2003):1301–1328.

2.ValentinDimitrovandPremC.Jain,“RecapitalizationofOneClassofCommonStockintoDual-Class:Growthand

Long-runStockReturns,”JournalofCorporateFinance(2006):342–366.

ConclusionB=Baseball=Buffett

1.SeeRichardDawkins,TheSelfishGene(NewYork:OxfordUniversityPress,1990);andCharlesDarwin,TheOriginofSpecies(NewYork:GramercyBooks,1979,originallypublishedin

1859).

2.JanetLowe,WarrenBuffettSpeaks(NewYork:JohnWiley&Sons,1997),85.

3.JohnTrain,MoneyMastersofOurTime(NewYork:HarperPaperbacks,2003),47.

4.MichaelLewis,Moneyball:TheArtof

WinninganUnfairGame(NewYork:W.W.NortonandCompany,2004).

E1BABOUT

Date:Jan19,2010

Time:10:25am

AbouttheAuthor

PremC.Jain,Ph.D.,C.P.A.,beganhisacademiccareerin1984at

theWhartonSchooloftheUniversityofPennsylvania,followed

byamovein1991totheFreemanSchoolofBusinessatTulane

UniversityinNewOrleans.In2002heacceptedhiscurrentpositionas

theMcDonoughProfessorofAccountingandFinanceat

Georgetown

University’sMcDonoughSchoolofBusiness.

JainhasalsotaughtatMonterreyTechinMexicoandtheChina

EuropeInternationalBusinessSchool(CEIBS)inShanghai,andwasa

visitingscholarfortwo

summersatINSEADinFrance.Hehastaught

graduate-levelcoursesincorporatefinance,investments,international

finance,andfinancialstatementanalysis.HehasalsoworkedasafinancialeconomistfortheCommodityFuturesTradingCommission(CFTC)in

Washington,D.C.

Overhis25-yearacademiccareer,Jainhastraveledacrosstheglobe

topresenthisresearchatvariousconferencesanduniversities.Hehas

publishedextensivelyinthemostprestigiousfinanceandaccounting

journals,includingtheJournalofFinance,JournalofFinancialEconomics,andJournalofAccountingResearch.Hisworkincludesseveralscholarlyarticlesanalyzingstockmarketandstockfuturesdata.HehasalsobeenreferencedintheWallStreetJournalandothernewsmedia.Hisresearchsubjectsincludestocksplits,spin-offs,mutualfundadvertising,performanceof

WallStreetsuperstars,andmarketefficiency.

E1BABOUT

Date:Jan19,2010

Time:10:25am

abouttheauthor

AtTulane,JaindevelopedacourseforMBAstudentstostudytra-

ditionalvalueandgrowthinvestmentstrategies,initiallydevelopedby

BenjaminGraham,DavidDodd,andPhilipFisher.Thestudentsalso

studyWarrenBuffett’swritingsanddecisionsalong

withcontemporary

financeresearchandmanageatwo-million-dollarportfolioaspartofthe

Universityendowment.Hefrequentlytakesstudentsandotherfaculty

memberswithhimtoBerkshire’sannualshareholders’meetings.

Jainreceivedabachelor’sdegreeinengineeringfromBirlaInstitute

ofTechnologyandScienceinIndiaandworkedasanengineerfortwo

yearsatHindustanMotors,anIndiancarmanufacturingcompany.He

receivedanMBAfromtheIndianInstituteof

Management,Calcuttaand

workedfortwoyearsasafinancialanalystforNovartis.Hereceiveda

Master’sdegreeinAppliedEconomicsfromtheUniversityofRochester,

aPh.D.fromtheUniversityofFlorida,andhisC.P.A.licensefromthe

StateofFlorida.

E1BINDEX

Date:Feb4,2010

Time:2:56pm

AbuDhabiInvestmentAuthority,252

Bankruptcy,189

AccountingGoodwill,133,134,223–228

BarnesandNoble,208

andearnings,225–226

BearStearns,151

andprofitabilityofacquiredbusinesses,

Bel-OroInternational,119

226–228

BenBridgeJeweler,118

Accountingskills,valueof,221–222

BerkshireHathaway,3,29–30,31,32

Acquisitions,corporate,17–18,258

acquisitioncriteria,75–76

criteria,75–76,131–135,136

annualizedreturn,6

reasonsfor,226

BerkshireHathawayReinsuranceGroup,

AdvancedMicroDevices,53

103–105,107–108

Advertising,116

capitalallocation,140

Agediscrimination,19

andcapitalintensity,212–213

Airlineindustry,15–16

Coca-Cola,44

Akerlof,George,237

compensationofdirectors

andexecutive

Amazon.com,273

officers,265–266

AmericaOnline(AOL),237,273

diversification,163

AmericanBankersInsuranceGroup,

dividendpolicy,251–252

186–187

GEICO,89–97

AmericanExpress,11–12,32,163,190,

GeneralReCorporation,99–103,

203,208,212,259,270

AmericanInternationalGroup(AIG),

asgrowthstock,70–71

106–107,188

historyof,9–22

Anderson,Ron,273–274

holdings,examplesof,77–

83,115–121,

Anheuser-Busch,259

140–142,151

Appearanceversusreality,14

intrinsicvalue,63–67

Arbitrage,185–188

andmanagementquality,52

Assets,58

MidAmericanEnergy(MEC),129

AuraLLC,119

andrepurchasesofitsown

stock,260

Balancesheets,58–59

ScottFetzer,17,137–140

Bankingindustry,15

versusS&P500,70

E1BINDEX

Date:Feb4,2010

Time:2:56pm

BerkshireHathaway(Continued)

BurlingtonNorthernSantaFe,16,67,

valueplusgrowth,73–74

77–80,151,173,207,211,212,215,

WashingtonPostCompany,150

WescoFinancialCorporation,58–61

Buyingandsellingpatterns,234–235

Beta,145,180

BYD(or“BuildYourDreams”),83–85

BethlehemSteel,35

Byrne,Mark,189

Bezos,Jeffrey,273

Black,Fischer,252

CapitalCities/ABC,173

BlueChipStamps,95–96

Capitalexpenditure,12–13

Blumkin,Irv,125,126

Capitalintensity

Blumkin,Rose,123–124,132

andmanagementquality,214–216

Bookvalue,36–37

Capital-intensivecompanies,211

Borsheim’s(jewelrystore),115–117,119,

Carefour,206

CarnivalCruiseLines,201

BostonCeltics,202

Case,Steve,273

Bridge,Ed,118–119

Cash,liquidityandopportunity,

Bridge,Jon,118

155–159

Brin,Sergey,275

Cashflow,96

BuffaloNews,198–199,200

anddividends,253,255

Buffett,Warren,3,6–7,25,29,31,34,43,

asking,10–11

54,69,72–73,74–75,84,89,137,

andrepurchasing,258

243,275

cash-flow-toprice,37–38

andacquisitionsphilosophy,75–76

Cendant,186–187,267–268

andarbitrage,185,187–188

Chace,MalcolmG.,95

Berkshire,transformationof,into

Challenges,companyresponseto,51

insurancegiant,95

ChampionInternational,73–74,157

Berkshirehistory,significanteventsin,

Chan,Louis,181

9–22

CharlesSchwabInc.,273

andcatastrophes,106

Child,Bill,125,126

circlesofcompetence,52

Chipotle,54

andefficiencyofthemarket,177

Chrysler,268

onfurnitureretailingbusiness,123

“Cigarbutt”approachtoinvesting,

GEICO,205

andGeneralReCorporation,102

Circleofcompetence,10,16,52,74,96,

geniusof,281–282

219,279

andGoodwill,223

Cisco,43,50,201,202

independence,respectfor,125

Citicorp,30

integrityof,270

Citigroup,252

jewelrybusiness,115

Coca-Cola,13–14,29–30,43,59,60,77,

aslargestBerkshireHathaway

149,163,201,203,233,237,246,

shareholder,273

258,259

andliquidity,155

asagrowthstock,44–45

andlong-terminvesting,169–170

intrinsicvalue,exampleofimportance

managementphilosophy,265

of,61–63

reinsurance,99

Comment,Jeff,116,118

andrisk,145,146

Commonstocks

andstockrepurchases,257,259,

evaluationof,examples,58–66

versusmutualfunds,4–5

andtheutilityindustry,129

Compac,232–233

Buffettinvesting,85

Companyprominence,29–30

valueplusgrowth,69–85

Compaq,50

E1BINDEX

Date:Feb4,2010

Time:2:56pm

Compensationissues,124,139,173

DowChemical,151,158,159

BerkshireHathaway,263–266

DowJonesIndustrialAverage(DJIA),164,

stockoptions,266–268

Competition,123–124

DowJonesTransportationIndex,213

Compounding,112

Downsiderisk,72,73,74,77,83,151–153

CompuAdd,50

Dreman,David,40

ConocoPhillips,163,212,223,224,244,

Drucker,Peter,18

Duopolies,201

Conservativefinancing,29–30,34,41

DuPont,E.I.,274

ConstellationEnergy,156

Convertiblebondsand

preferredstocks,

Earnings

157–158

growthin,asdriverofstockprice,47

Corporateacquisitions,17–18,258

manipulationof,12

Corporategovernance,249,263–271

andsales,importanceoftrackrecord,

Corporatejets,13

47–54

CORTBusinessServices,126–127

volatility,asbenefit,93

Costadvantage,115,116–117,209

Earningsforecasts,74

Costco,206,217–218,220,252

EatonVance,54

Costs,waystoreduce,209–210

Efficiencyofthemarket

Counterparties,increditdefaultswaps,107

andacademics,179–181

CourierNews(Buffalo,N.Y.),198

Eisner,Michael,173

Creditdefaultswaps,106

Ellison,Larry,273

CSFB/TremontHedgeFundIndex,190

Enron,21,133,134,151

Customerservice,208

Euphoria,32

asinvestor’senemy,15,19

DairyQueen,225

sellingin,20–21

Danaher,54

Eventstudies,180

Davidson,Lorimer,90

ExecutiveJetAviation,225

deBeers,197

Executiveofficers,compensationof,

Debt,133

265–266

Debt-to-equityratio,29

Extreme-valueportfolios,37,40

Dell,Michael,50,273

Exxon,186

DellComputer,50,232–233,273

Demandandsupply,180

Fama,Eugene,37

Derivatives,21–22,146

Familyfirms,274–275

DinersClub,208

FannieMae,244

Directors

Fast-growingindustries,74

compensationof,265

FedEx,201

groupthink,266

Financialresults,269

Disaster,maintainingfocus,21

reportedversustrue,12

Discountrate,67

FirstEmpireState,74

Disney,171,173,201

Fisher,Philip,43,53,165

Dittmar,Amy,257

FlightSafetyInternational,18–19,80–81,

Diversification,161–167

132,214

avoidingexcessive,164–165

Float,60

international,165–166

GEICO,90,92–93

Dividends,58,251–255

andinsurancebusiness,100,101–102

anddoubletaxation,252

asinterest-freeloan,92,94,97

monitoringroleof,253

andtradingstampservice,95–96

Do-it-yourselfstores,207

Float-to-revenuesratio,101

Dollar,declineinvalueof,152

Ford,Henry,274,281

E1BINDEX

Date:Feb4,2010

Time:2:56pm

Foundercontrol,273–275

researchanddevelopment,49–51

Franklin,Benjamin,13,96,281

responsetochallenges,51

FreddieMac,171,174

Growthpotential,131,133,134,225

French,Kenneth,37

Growthrate,58,225

Friedman,Ike,116,117

Growthstocks

Fundamentals,25,180

examplesofprospects,77,81,83

Futureearnings,58

identificationof,46–47

non-high-tech,54–55,130

Gannett,199

Gates,Bill,244,270

Hedgefunds,185,188–192

GEICO,11–12,18,71–72,81,89–97,

indicesandsurvivorshipbias,

104–105,205,206–207,208,210,

managementfeestructure,191

Helzberg,Barnett,117,118,119

compensationplan,263–264

Helzberg,Gilbert,117

versusGeneralRestrategies,103

Helzberg,Morris,117

intrinsicvalue,calculationof,94

HelzbergDiamonds,115–119

marketing,90,93

Herdinginstinct,232–233

valuationandreturnstoBerkshire

HewlettPackard,232,274

Hathaway,94

High-profit-margincompanies,52–53,

GeneralElectric,30,74,151,156,158,

199,201

159,165,172,268

High-techcompanies,50,74

GeneralMills,166

BYD,83–85

GeneralMotors(GM),171,199,207

Hiringpractices,18–19

GeneralRe,99–103,107,186,225

Holdingperiods,13–14,146–147

compensationplan,267

sellingtooearly,18

andfloat,101–102

HomeDepot,46,49,50,54,268

versusGEICO,103

history,1998-2008,101–102

IBM,50,51,165,199,207–208,219–220,

Gillette,74,157,158

Glamourstocks,35,36,41

profitabilitycomparisonwith

Microsoft,

GlobalMarine,48

196–197

GoldmanSachs,30,74,151,156,158,159,

Incentiveplans,271

172,188

symmetrical,264–265

“Goodcompany,”131,132–133

Indexfunds,4–5,112

Google,46,51,52,275

Inefficiencyofthemarket,181–183

Gordon,Myron,62

Inflationrisk,151–152

Gottschalg,Oliver,191

Initialpublicofferings(IPOs),47

Governance,corporate,249,263–271

Insurancebusiness,14,89–97,205–206

Graham,Benjamin,26–27,29,33,34,36,

and9/11terroristattacks,101,156–157

40,89,164

BerkshireHathawayReinsuranceGroup,

growthinvesting,45–46

103–105

Groupthink,266

Berkshire’sexperiencepriortoGEICO,

Growthinsales/assets,37–38,73

Growthinvesting,23,43–56,72–73,

float,90,92–93,94

GEICO,89–97

defined,43,44

GeneralRe,99–102

long-termperspective,51

operatingprofits,90–92

andone-timeevents,48

sizeandrisk,99–100,156–157

profitmargins,53–54

Integrity,270,281

qualityofmanagement,52–53

Intel,43,50,53,201,202

relationshipwithemployees,49

Interest-freeloans,109–112

E1BINDEX

Date:Feb4,2010

Time:2:56pm

Internet,48,51

Luxuries,13

effectof,onthebook

industry,208

Lynch,Peter,47–48,124,166,179,202,

Intrinsicvalue,56,57–68,74,172,202,

203,282

BerkshireHathaway,62–67

MacKinlay,A.Craig,179

Coca-Cola,61–63

Malkiel,Burton,190

computing,57–66

Management

GEICO,94

compensationfordirectorsandexecutive

Wesco,61

officers,265–266,268–269

Inventoryturnover,209

andgrowthinvesting,52–53

Investingasgame,3–4

identifyinghighquality,25,68,75,94,

mind-settowin,277–279,

108,131–132,268–270,282

Investingonmargin,151

incentives,124,139

Investmentstrategy,7

qualityandcapitalintensity,214

basisprinciples,281–282

Managers

valueinvesting,25,35

andBerkshirejewelrybusinesses,121

Iscar,156,214,225

examplesofoutstanding,14,80,81–82,

84,116

Jain,Ajit,103

identificationoftop,importanceof,11,

J.C.Penney,206

16–17,130,142,279–280

Jegadeesh,Narasimhan,181

andindependence,125

Jewelrybusiness,115–121

integrity,270

Johnson&Johnson,172,243

NebraskaFurnitureMart,124

Jordan’sFurniture,126

nomandatoryretirementage,132

J.P.Morgan,151

self-perpetuationofhigh

quality,52

Manufacturingcompanies,137–142

Kaplan,Steve,191

Marginofsafety,67,73,74–75,202

Kaypro,50

Marketcrashes,2008-2009,22,70

Kelleher,Herb,210,214

Marketefficiency,175,177–183,179–181

KernRiver,134,208

Marketinefficiency,181–183

Kmart,33,35,53,205,206,207,209,

Marketshare,81,209

Borsheim’s,115

KraftFoods,59,60,259

GEICO,91

Market-to-bookratios,23,26,29,38,69,

Lakonishok,Joseph,35,37,38,41,181

Leadercompanies,characteristicsof,

206–209

performanceofhighversuslowM/B

LeggMason,244

stocks,36–37

Lenovo,51

Markettrends,237

Leverage,152,188–189

Marketvalue,36–37,58,59

Liquidity,152

Wesco,60

andopportunity,155–159

MarketingGEICO,90,93

problems,189

MarmonHoldings,140,141,214

Lo,Andrew,179,191

Martin,Gerald,71

Long-TermCapitalManagement,153,

Mauboussin,Michael,244

188–190

Maximizationofshareholdervalue,75

Long-termdebt,29

McDonald’s,49,54–55,171,172–173,

andCoca-Cola,30

Long-termfocus,89,93,170,233

McLaneCompany,140,141–142,226

Long-termreturns,72,111–112,133

Mergerdeals,arbitragein,186–187

Low-qualitystocks,33

MerrillLynch,32

E1BINDEX

Date:Feb4,2010

Time:2:56pm

Microsoft,43,46,48–49,50,

51,52,165,

andstockmarketcrash,6

201,202,203,225

andvolatility,147–148

dividendpolicy,253–255

Oracle,273

asnear-monopoly,195–196

Overconfidencebias,238

profitabilitycomparisonwithIBM,

Ovitz,Michael,173

196–197

Owner-managers,273–275

MidAmericanEnergy(MEC),129–135

criteriaforacquisition,131–135

PacifiCorp,134

Miller,Merton,251

Page,Larry,275

Mind-settowin,277–279,281

Papergains,asinterest-freeloan,109

Mistakes,learningfrom,243–247

Pastperformance,58

MiTek,226

Patience,19–20,26,31,131,133,134,

Mobil,186

159,279

Modigliani,Franco,251

andNetJets,82

Momentuminstockprices,181

andvalueinvesting,38,40,41–42

Monitoringroleofdividends,253

Pepsi,201

Monitoringyourportfolio,39

Performance,returnonequity,217

Monopolies,195–203

Pessimism,asinvestor’sfriend,15,32

profitabilityof,196–199

PetroChina,171,172,211

Moody’s,259

Phalippou,Ludovic,191

MorganStanley,157

PhilipMorris,202

Mortgages,payingoff,152

Portfolioformation,38–39

Motivationofemployees,263

Portfolioinsuranceeffect,148–149,

Motorola,274

Munger,Charlie,58,84,96,109,127,132,

POSCO,211

198,211,214,226,275

Preferredstock,157–159

Murphy,Tom,173

Preservationofcapital,26

Mutualfunds,4–5

Pricediscrimination,209

Price-to-earningratios(P/E),23,26,

Nardelli,Robert,268–269

27–29,38,58,73,202,203,281

Naturaldisasters,14,21

averageearningsovertime,27–29

Near-monopolies,196,201

andexcellentmanagement,132

NebraskaFurnitureMart,16–

17,123–124,

125,130,132

performanceofhighversuslowP/E

Neff,John,28–29,165

stocks,35–36

NetJets,81–82,210,226

andvalueinvesting,69

NewYorkTimesCompany,199

Prince,Charles,252

Nicely,Tony,207

Principlesforinvesting,26–30,281–282

NorthernNaturalGas,134,156,208

examplesforhistoryofBerkshire

Hathaway,10–22

Odean,Terrance,239

Privateequityfunds,191

Operatinglosses,93

Procter&Gamble,59,60,74,158,163,

Operatingprofits,GEICO,90–92

172,203,223,224,225

Opportunity,25

Profitmargins,53–54

andgrowthinvesting,55

Profitability,119–121,193,196–199

industrythatleadsthedecline,32

ofhigh-capital-intensitycompanies,

andliquidity,155–159

215–216

sharpdeclineinthestock

market,30–32

andmonopolies,195,196,199,201

andsharpdeclineof1987,148–149

sustainabilityof,202

andslowdeclinein1973-1974and

versustotalprofits,139

2008-2009,149–151

Prominenceofcompany,29

E1BINDEX

Date:Feb4,2010

Time:2:56pm

Property,plant,and

equipment(PPE),

Ritter,Jay,47

212–213

Russiandefaultcrisis,32,153

Psychology,229,231–242

biases,238–240

Safety,155–157

herdinginstinct,232–233

Saha,Atanu,190

Puthenpurackal,John,71

Salesandearnings,importanceoftrack

record,47–54

Qualitativeapproach,72–73

SalomonInc.,74,157,158,

243–244,270

Quantitativeapproach,72–73

Sam’sClub,51

Santulli,Richard,81–82

Rateofreturn,4–5

Schey,RalphE.,137–138,140,264

andutilities,131,134

Schmidt,Eric,275

Rationality,282

Schoar,Antoinette,191

R.C.WilleyHomeFurnishings,125

Schulz,Howard,273

Realestate,152

Scott,Walter,129,130

Reeb,David,274

ScottFetzer,17,137–140,264

Reinsurance,99–112

Sears,206

defined,99

See’sCandies,226

risks,103–105

Shareholders

ReinsuranceGroup,103–105,107–108

large,asfriends,273–276

RelianceGroupHoldingsInc.,105–106

unfairnessofstockoptions,266–268

Reportedearnings,58

Sharpe,Lintner,andBlack(SLB)model,41

Reportedversustruefinancialresults,12

Shaw,RobertE.,140

Repurchasesofstock,253,254,257–261

ShawIndustries,140–141,142,226

Reputation,116,118,119,127

Shiller,Robert,148,237

andsaleofstock,173

Shleifer,Andrei,35

Researchanddevelopment(R&D),

“Shoppertainment,”126

49–51

Short-termdebt,29

inhigh-techcompanies,50

Short-termvolatility,146

Responsibility,taking,20

Silverman,Henry,267–268

Results,extraordinaryinordinarybusiness,

Sizeofcompany,29–30

insurancebusiness,99–100

Retailsector,113,115–121

Sloan,AlfredP.,207

Retirementage,132

Smallinvestor,advantagesof,6

Returnonassets(ROA),218,220–221,

Sokol,David,81,84

Soros,George,236

Returnonequity(ROE),217–221,

SouthwestAirlines,210,214

S&P500index,31,164,172,190,191,

Risk,15–16,143,180

274,275

arbitrageandhedgefunds,185–192

annualizedreturn,comparisons,6

andcapitalintensity,213,216

StandardOil,195,203

defined,145–146

StarFurniture,125–126

downside,151–153

Starbucks,43,48,54,273

andhedgefunds,190–191

andholdingperiod,146–147

managementinterestin,267,270

lowdebtlevel,282

pricemomentum,181

tolerance,31,57

reasonstosell,171–172

andutilitysector,129,130

repurchasing,253,254,257–260

andvalueinvestmentstrategies,

selection,182–183

40–41

whentobuy,67

Risk-takingbehavior,107

whentosell,169–174

E1BINDEX

Date:Feb4,2010

Time:2:56pm

Stockoptions,266–268

BenjaminGraham,26–27

unfaircosttoshareholders,267–268

andconservativefinancing,29–30

Stockprice,growthinearnings,47

evaluationof,34–38

Stocksplits,16

examples,77,80,81,83

Subaru,202

andGEICO,71–72

Sunk-costfallacy,172

andmonitoringtheportfolio,39

Survivalinstinct,277

otherhelpfulguidelines,30–34

Survivorshipbias,190

preservationofcapital,26

Sustainabilityofprofitability,202

andprice-to-earningsratios,26–29

SwissRe,151,158,159

ValueLine,29

Valueplusgrowthconcept

Target,206

implementationof,73–75

Tatelmanbrothers,126

Valuestocksversusgrowthstocks,46

Taxdeferment,109–112

VanguardWindsorFund,28

Technology,effectiveuseof,209–210

Venturecapitalfunds,191

Templeton,John,178–179

Vishny,Robert,35

Tesco,206,212

Volatility,146,147–148,183

Timeframes,38–39,42

andhedgefunds,191,192

TimeWarner,237

Timingthemarket,32,39

Wal-Mart,33,43,49,50,51,53,54,81,

difficultyof,150

90,115,124,165,203,205,

206,207,

TIPs,152

208,209,210,246,273,274

Trading,frequencyof,andmutualfunds,

asgrowthstock,46

110,112

andMcLaneCompany,141–

Travelers,171

Walton,Sam,46,47,49,54,116,118,207

Treasurybonds,long-termzero-coupon,19

WashingtonPost,31,150,199,201,203,

“Turnaround”companies,

11–12,33

258–259,270

Welch,Ivo,47

Uelstchi,A.L.,80,132

WellsFargo,59,60,77,163,203,212,

Undervaluation,andcompanyrepurchases,

257,261

WescoFinancialCorporation,58–61,126,

Underwritinglosses,101

Underwritingprofits,90–92

float,60

UPS,201

WestEndCapital,189

U.S.Airways,74,157,158,211,214

Whitman,Bruce,80

U.S.Bancorp,212

WholeFoods,203

U.S.Steel,214

Wolff,Melvyn,126

Utilitycompanies,129–136

WorldCom,151,222

andregulation,129,130

Wrigley,74,151,156,158–159,172

W.T.Grant,206

Valuation,GEICO,94

Valueinvesting,23,25–42,69,281

Yahoo!,54

academicresearchevidencefor,34–35

Yermack,David,267

(continuedfromfrontflap)

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(continuedonbackfl

DocumentOutline

BuffettBeyondValue:WhyWarrenBuffettLookstoGrowthandManagementWhenInvesting

ContentsPrefaceAcknowledgments

PartOne:INTRODUCTIONANDBACKGROUND

Chapter1:TheThrillofInvestinginCommonStocks

Howa1PercentAdvantageBecomesa100

PercentGainHowMuchWouldYouHaveEarnedIfYouHadInvestedwithBuffett?Conclusions

Chapter2:1965–2009:

LessonsfromSignificantEventsinBerkshireHistory

1965:NotThrowingGoodMoneyafterBad1967:InvestinYourCircleof

Competence1973:CashFlowIsKing1977:SuccessfulGrowth1980:BuyingSharesafterPricesFall

1984:ReportedVersusTrueFinancialResults1985:CapitalExpenditures1986:CorporateJetsandOtherLuxuries

1988:HoldingPeriodofanInvestment1989:LookingFoolishVersusActingFoolish1990:PessimismIsYour

Friend1991:Risk1992:StockSplits1993:IdentifyingExcellentCEOs1994:ExtraordinaryResultsinOrdinary

Businesses1995:CorporateAcquisitions1996:SellingTooEarly1996:HiringPractices1997:Patience1999:Taking

Responsibility2000:SellinginEuphoria2001:NotLosingFocusWhenDisasterStrikes2002:FinancialWeaponsofMass

Destruction2008-2009:MarketCrashesConclusions

PartTwo:BUFFETTINVESTING=VALUE+GROWTH

Chapter3:ValueInvesting—

It’sLikeBuyingChristmasCardsinJanuary

ValueInvestingandTwoEssentialPrinciplesOtherHelpfulGuidelinesforValue

InvestingDoesValueInvestingReallyWork?FrequentlyAskedQuestionsConclusions

Chapter4:GrowthInvesting

ColaasaGrowthStockHowtoIdentifyGrowthStocksImportanceofTrackRecord:SalesandEarningsOneExample

ofaNon-TechnologyGrowthStockConclusions

Chapter5:IntrinsicValue

ComputingIntrinsicValueWhentoBuyAnyStock:Consider

MarginofSafetyConclusions

Chapter6:BuffettInvesting=Value+Growth

BerkshireHathawayIsaGrowthStockValue

PlusGrowthExamplesfromBerkshireInvestmentsConclusions

PartThree:OTHERPEOPLE’SMONEY

Chapter7:Insurance:OtherPeople’sMoney

InsuranceCompaniesasOtherPeople’sMoneyConclusions

Chapter8:Reinsurance:MoreofOtherPeople’sMoney

SizeMatters:Berkshire’s

AcquisitionofGeneralReFailureofRelianceInsuranceCompanyConclusions

Chapter9:TaxDeferment:Interest-FreeLoansfromthe

GovernmentValueofBerkshire’s$10BillionInterest-FreeLoanfromtheGovernmentReturnsona$10,000Investmentin25

YearswithandwithoutTaxDefermentConclusions

PartFour:SUCCESSINRETAILING,MANUFACTURING,ANDUTILITIES

Chapter10:IfYouDon’tKnowJewelry,

KnowYourJeweler

ComparisonwithWal-Mart:CostAdvantageHelzbergDiamonds,BenBridgeJeweler,andOthers

Profitability:Berkshire’sJewelryBusinessesversusTiffany&Co.Conclusions

Chapter11:CompeteLikeMrs.B

KnowWhenNotto

Compete:NebraskaFurnitureMartR.C.WilleyHomeFurnishingsStarFurnitureandJordan’sFurnitureCORT

BusinessServicesConclusions

Chapter12:WhyInvestinUtilityCompanies?

SimilaritybetweentheMECandOtherAcquisitionsFourNonprice

AcquisitionCriteriaConclusions

Chapter13:HighProfitsinHonest-to-GoodnessManufacturingCompanies

ScottFetzer’sSuccessShawIndustries,

Marmon,andMcLaneConclusions

PartFive:RISK,DIVERSIFICATION,ANDWHENTOSELL

Chapter14:RiskandVolatility:HowtoThinkProfitablyaboutThem

RiskandReturn:HoldingPeriodVolatilityOffersOpportunitiesOpportunitiesfromtheSharpDeclineof1987ASlowDecline

in1973–1974and2008–2009MoreonDownsideRiskConclusions

Chapter15:WhyHoldCash:LiquidityBringsOpportunities

LiquidityandOpportunitiesBerkshire’sInvestmentsinConvertiblesRecentBerkshireInvestments:Wrigley,GoldmanSachs,General

Electric,SwissRe,andDowChemicalConclusions

Chapter16:Diversification:HowManyBasketsShouldYouHold?

DiversificationHowDiversified

IsBerkshireHathaway?HowManyStocksShouldYouHold?PhilipFisherWarnsagainstToo

MuchDiversificationDiversificationand“Diworsification”Conclusions

Chapter17:WhentoSell

TurnoverofBerkshire’sEquityPortfolio:Why

BuffettHoldsAlmostForeverTwoMainReasonstoSellConclusions

PartSix:MARKETEFFICIENCY

Chapter18:HowEfficientIstheStock

Market?CanIMakeMoneyintheStockMarket?MostAcademicsFavorMarketEfficiencyRecentEvidenceon

MarketConclusions

Chapter19:ArbitrageandHedgeFunds

ArbitrageinMergerDealsAnExampleofaSuccessfulArbitrageDealby

BuffettLong-TermCapitalManagement:TheStoryofaHedgeFundandBerkshireHathawayShouldYouInvestin

HedgeFundsorPrivateEquityFunds?Conclusions

PartSeven:PROFITABILITYANDACCOUNTING

Chapter20:M=Monopoly=Money

theMoatProfitabilityofMonopoliesDominanceDoesNotMeanHighProfitsHowtoLookforMonopoliesDoNotSella

MonopolyinaHurryConclusions

Chapter21:WhoWinsinHighlyCompetitiveIndustries?

InsuranceIsaCommodityBusinessLike

RetailingTwoMainCharacteristicsofaLeader:LowCostandCustomerSatisfactionHowDoCompaniesKeepCosts

Low?Conclusions

Chapter22:Property,Plant,andEquipment:GoodorBad?

CapitalIntensityCapitalIntensityandManagementQuality

ConclusionsChapter23:KeytoSuccess:ROEandOtherRatios

ROE:UnderlyingPerformanceofaBusinessROA:ReturnonAssets

BuffettandAccountingConclusions

Chapter24:AccountingGoodwill:IsItAnyGood?

AccountingGoodwillandItsEconomicValueGoodwill

andEarningsGoodwillandProfitabilityofAcquiredBusinessesConclusions

PartEight:PSYCHOLOGY

Chapter25:HowMuchPsychology

ShouldYouKnow?

HerdingandYouExamineYourBuyingandSellingPatternsCanYouChangeYourself?How

PsychologyMayHelpYouHowtoThinkaboutPsychologicalBiasesSomeImportantQuestionsforYoutoConsider

ConclusionsChapter26:HowtoLearnfromMistakes

MistakesversusBadLuckLearningfromMistakesMistakesofCommissionand

MistakesofOmissionConclusions

PartNine:CORPORATEGOVERNANCE

Chapter27:Dividends:DoTheyMakeSenseinThisDayandAge?

BerkshireDoesNot

PayDividendsMicrosoftandaSpecialDividendConclusions

Chapter28:ShouldYouInvestinCompaniesThatRepurchaseTheirOwn

Shares?ShareRepurchasingIsGoodNewsShareRepurchasesbyCompaniesinWhichBerkshireHasInvestedWhy

Doesn’tBerkshireRepurchaseItsOwnShares?Conclusions

Chapter29:CorporateGovernance:Employees,Directors,andCEOs

EmployeeCompensation

atBerkshireCompensationforDirectorsandExecutiveOfficersWhatIsWrongwithCompensationthroughStock

Options?HowtoIdentifyGoodCEOsorOtherSeniorManagersConclusions

Chapter30:LargeShareholders:TheyAreYourFriends

FounderControlMattersConclusions

Conclusion:B=Baseball=Buffett

Don’tLoseMoneyStayinYourCircleofCompetence

FindGoodPeople

Appendix:ASummaryoftheBook

NotesAbouttheAuthorIndex

Buffett beyond value

Business

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