Warren Buffett is the undisputed heavy-weight champion of investing. Why not learn from the best? As a student of value investing I am always trying to learn more about how Warren Buffett thinks.
Many of his patterns repeat over time. The more we learn about those patterns, the more we can exploit hidden investment value.
Too Big To Succeed
He now runs a multi-billion-dollar fund. It is hard to extrapolate from his current choices of investments to something that you or I could do.
He is very limited in his stock choices due to the huge size of his fund. He had more liberty as an earlier investor when his funds were more limited.
Lessons From His Early Successes
It is instructive to look back at Buffett’s early Berkshire Hathaway investments. You likely shouldn’t let this be your only investing process. Consider using this value-based method for a porting of your higher risk investing.
He had outstanding returns when he was running his partnership from 1957 to 1968. His investing style became clear early. He always searched for value.
The Value Investing Theme
That was easier to do when employing $25M instead of $25B. He has looked for a low price when compared to value.
He also looks for consistent earnings. He invests in profitable companies.
The most common “cigar butt” companies are bleeding cash and not making a profit. Those companies would not interest Warren.
He chooses industries and businesses that he can understand. He talks to and understands its customers. He observes trends and acts on them.
Do Your Due Diligence
Before investing in American Express he did his own research on customer demand. He spent time in restaurants watching how many people used a charge card.
He talked with the restaurant owners to get a sense of trends. He also knew the management and what it would take to improve things.
He looked for companies with a consistent return. He picked companies that ended up having an after tax Return on Capital ≥ 20%.
But at What Price?
He preferred companies with a lower P/E ratio (e.g. ≤ 15). Mr. Buffett doesn’t rely on Earnings Before Interest and Taxes (EBIT). But for modern investors looking back the multiple of Enterprise Value (EV) per EBIT is useful metric of value (lower is better).
An Enterprise Value divided by Earnings Before Interest and Taxes is a useful ratio. 5 or less would be a bargain but finding a stock that cheap isn’t always possible.
He also looks for consistent growth and profit over a long time. He might pay a little more if he is certain the earnings will continue and grow.
He has stated he would be comfortable with a ratio of 7 if the expected earnings growth is 8-10%.
Modern Value Tools
Yefei Lu is a modern value investor. He used current valuation tools to study Buffett’s investments. Lu wrote about his approach in his book, Inside the Investments of Warren Buffett. His findings are instructive and I will highlight some of those findings here.
Principles in Action
IBM. 2009. P/E=17. EV/EBIT=12.9
Burlington Northern. 2006. P/E=15.2. EV/EBIT=10
Burlington Northern. 2008. P/E=16.5. EV/EBIT=11
Wells Fargo. 1989. P/E=5.3
US Air. 1987. P/E=6.6. EV/EBIT=9
Capital Cities/ABC. 1985. P/E=14.4. EV/EBIT=8.3
Nebraska Furniture Mart. 1983 P/E=8.5. P/B=0.80. EV/EBIT=4.3
Washington Post. 1972. P/E=10.9. EV/EBIT=5.3
See’s Candy. 1972. P/E=11.9. EV/EBIT=6.3. He planned a 30% margin of safety by forecasting 3-5% annual growth.
American Express. 1964. Shares were selling at $60 per share. Buffett waited until the price came down to $35 per share after the bad publicity from the salad oil scandal.
Greatness at a Good Price
He felt at that point it was a great business at a reasonable price. P/E=16. EV/EBIT=8 to 11 depending on assumptions.
Did you notice a pattern with all those low P/E, low multiple stocks? They don’t look like the growth stocks your modern broker will try to push on you as the “next Microsoft.”
You would be better off emulating Buffett and Graham. Buy stocks whose valuations look like those listed above.
Not All Assets are Equal
On the balance sheet assets are assets. Inventory, property and equipment, accounts receivable are examples of assets.
Distressed low-price companies come with a very real possibility of bankruptcy. Stock investors will lose when the entire enterprise fails.
In that scenario a prepaid expense or inventory is definitely not as valuable as cash. How could you adjust the relative values?
Margin of Safety
Buffett took Graham’s lesson on “margin of safety” to heart. When buying Buffett made conservative assumptions about the company’s assets and liabilities.
The Value of Book Value
Dempster Mill in 1961 is a particularly instructive case for the value investor. Buffett looked at the book value (BV) per share before buying. The BV was $76.50 per share. Its Assets (6,919) minus Liabilities (2,318) = 4,601.
Assets on the Books
Divide this by shares outstanding (60,146) to yield $76.50. The illustrative part of this is how Warren assessed the assets on the books. He left the liabilities alone but adjusted the asset values down.
Only Cash is King
This is a conservative approach taught by Benjamin Graham. Cash is cash so he left that alone.
He thought PP&E’s auction value would be 58-74% on the dollar. So, he reduced the balance sheet value.
How to Adjust Asset Values
Accounts receivable he multiplied by 85%. Inventory he multiplied by 60%.
Prepaid expense he reduced by 75%. The reductions vary. Generally, we can expect a 50-75% range. If a company goes bankrupt it will not get 100% dollar for dollar on all its assets.
Brilliant, eh? This seems obvious but who does this? Well, Warren Buffett and Benjamin Graham did.
Since they are two of the most successful value investors of all time you and I should do that too.
Using the adjusted and more conservative asset value (4,438) and the same liabilities number (2,318) = 2,120 or $35/share. In 1958 and 1959 the company had positive earnings.
Dynamic Sales & Inventory
He noticed the sales were static and the inventory turnover was low. He felt better management could fix that. His average buy price was $28/share.
That provided a 20% discount per his adjusted accounting methods. Using traditional accounting that discount was still 63%.
That is a wide margin of safety either way that allowed him to buy his shares below book value.
For more about Buffett’s early investments see Yefei Lu’s book.
BIO: This post is brought to you by Wealthy Doc. Wealthy Doc is a practicing physician. He uses his finance MBA and 30+ years of investing experience to help physicians and other professionals with money matters. Despite growing up poor, he is now debt-free and financially independent. His investment income exceeds his salary. He blogs at https://wealthydoc.org