Warren Buffett is the iconic Chairman of Berkshire Hathaway, a publicly listed company on the New York Stock Exchange. As the accompanying graph (below) shows, had you invested $10,000 into Berkshire Hathaway shares in early 1965, when Buffett first invested in the company, your investment would now be worth just over $36 million (at end 2008) for a 20.5% compound per annum return. The same $10,000 invested in the S&P 500 Index would have been worth $0.43 million (at end 2008) for a compound per annum return of 8.9%. Unquestionably, Buffett is the most successful stock market investor of all time. He is the second richest man in the world, behind Microsoft’s Bill Gates, and he is unique for having built his fortune entirely through his stock market investment activities. In mid 2006, he announced that he was passing the bulk of his wealth to charity, via the Bill & Melinda Gates Foundation.
This article is our effort to provide a better understanding of how Buffett achieved his success. Buffett’s own autobiography, Snowball, is an enjoyable read but, personally, I didn’t feel it gave the business understanding that underpinned Buffett’s key investments. In contrast, ‘The Warren Buffett Way’ written by Robert Hagstrom in 1994 (2nd edition published later) was, in my view, the best book written on the Buffett phenomenon, and I highly recommend it along side Buffet’s auto biography ‘The Snowball’.
The Ben Graham Influence
Having trained under the infamous value investor, Benjamin Graham (author of the investment classic ‘The Intelligent Investor’), Buffett established his own investment partnership in the 1950s (when Graham retired) and concentrated on buying companies with a significant ‘margin of safety’ to underlying value, which of course is easier said than done. One of Graham’s approaches, which Buffett followed, was to buy companies at below the value of their net working capital after deducting all debt and other liabilities. Graham described this as the ‘liquidation’ approach. Net current assets includes trade debtors, stocks and short term cash balances less trade creditors, accruals and any short term debt. But Graham would also deduct any other (long term) debt. In essence, he was buying businesses below the value at which realisable assets could be sold (or liquidated). Value-based approaches like this stood Buffett well and between 1955 and the end of 1968 he compounded his monies at nearly 30% per annum. By the late 1960s, he was already a wealthy man. Buffett, himself, described such value approaches as ‘cigarbutt’ approaches. Often he was buying poor businesses but he was getting such a large ‘margin of safety’ that he could still get a decent return. As he said, it was like picking up a discarded cigar butt that had a few free puffs left in it.
He ended the partnership in early 1969 because he felt he could no longer find the value he was used to. In his own words, he was out of touch with the times. The reality, of course, was that his insistence on value meant that he correctly judged that the market was overvalued at that time. The US Stock Market entered a bear market shortly thereafter.
From 1969 onwards, Buffett’s investment activities were concentrated through his publicly quoted vehicle, Berkshire Hathaway, which he had taken control of in 1965. Also at this time, he started to move away from the strict value principles of Graham and migrate towards buying big positions in growth companies when they were on offer at decent prices. The opportunity to buy such holdings arose with the onset of the severe bear market of 1973-74.
And when Buffett moved, he moved decisively. As an example, in mid 1973, Buffett bought 8% of the Washington Post. He subsequently increased the holding eventually ending up with an 18% stake for a total cost of $11m. Berkshire Hathaway still holds this investment, and by end 2008 the Washington Post holding was worth in the order of $674 million.
Another example of his ability to buy big during difficult times was his purchase of a 7% holding in Coca Cola throughout 1988 for just over $1 billion. The stock market was very nervous at that time following the crash of late 1987. It was a huge commitment for Berkshire as the Coca Cola investment represented circa 30% of Berkshire Hathaway’s assets at that point in time. In early 1989, when asked in a television interview about the risk of buying such a large holding in Coca Cola, Buffett quipped that it would not concern him if the stock market closed for the next ten years. His message, of course, was that he did not need the stock market to value his Coca Cola holding for him. So long as Coca Cola’s profits and cash flows grew over time, and he was sure they would, the value of his investment would also rise.
Certainty of Earnings & Growth
Buffett’s genius has been his ability to predict, with a significant degree of certainty, which companies were sure to deliver much greater levels of profits and cash flows on a ten and twenty year view. He then had the patience to wait and only buy such companies when they were on offer at good value, which is normally during difficult stock market or economic conditions. Buffett has been as comfortable buying 100% of private businesses as he is buying minority positions in publicly quoted companies. The quality of the business and the value he obtains when buying are the common characteristics of his investments.
The ‘Warren Buffett Way’ – a Must Read
In the book ‘The Warren Buffett Way’ (published in 1996), Robert Hagstrom examines the Buffett phenomenon and provides a brilliant analysis and understanding of how Buffett identifies his investments. The book and a sequel (published in 2004) can be bought on-line at any of the recognized on-line book retailers.
Eschewing Technology Stocks
In the late 1990s, Buffett had eschewed technology shares and the investment community began to question whether Buffett had ‘lost his touch’. The technology stocks were powering ahead and delivering massive returns to investors during the infamous ‘tech’ boom. But the returns proved to be a short term illusion as, by mid 2000, the technology sector crashed, wiping out the majority of the gains made in the late 1990s.
Buffett’s argument in the late 1990s regarding his decision not to buy technology shares was that he could not determine – with a high degree of certainty – what any technology company would be earning on a ten or twenty year view. If he could not do that then he certainly could not value the company, in which case he would not even consider buying the share.
Gaining Access to Leverage at No Cost
The foundation of Buffett’s success has been his ability to buy into outstanding businesses at favourable prices, to stay with these businesses over the long term, irrespective of general business or stock market conditions and to boost Berkshire’s returns further by using other people’s money (as opposed to borrowings). How he leveraged his investments is as interesting as his stock picking ability.
During the early years, Berkshire Hathaway acquired a number of insurance companies and through them Buffett found a way to use other people’s money so that he could more substantially profit from his superior investment expertise to the benefit of himself and the Berkshire shareholders. Insurance companies typically make money in two ways. They sell insurance policies to generate underwriting profits or losses (often losses). In addition, they generate investment income on the cash policy holders pay up front for the policies. Insurance companies are sometimes good investments and sometimes not.
Buffett recognised, however, that, with a constant pool of available cash, they could be terrific investment vehicles. Although these cash pools were there to pay for eventual claims, as an insurance company grows so too does the pool of cash to meet such claims. The traditional approach of insurance companies is to invest the majority of this pool of cash in guaranteed investment instruments such as government bonds. In so doing, management feel comfortable that they can always meet the obligations associated with claims and underwriting losses. However, the returns achievable on the “cash pool” from gilts or bonds are much lower, over the long term, than the returns available from investing directly in good businesses.
Buffett never followed the logic employed by the typical insurance company. His insurance companies were never run to produce underwriting losses and, freed from the distraction of such losses, Buffett has had the twin advantages of gaining access to these “cash pools” at zero cost (i.e. no underwriting losses) and being able to take a long term view when investing this cash. In essence, insurance companies provided Buffett with the cash resources with which to invest at a much earlier stage than he could have achieved on his own. He was able to leverage the returns for Berkhire shareholders in this way. The 20.5% compound per annum return achieved by Buffett since 1965 was over double the returns from the S&P 500 Index of 8.9% compound per annum over the same period. The 11.6% annual (compound) outperformance can therefore be partly explained by Buffett’s investment skills and partly by the leverage provided by Berkshire’s insurance cash pools.
However, to get hold of this cash at zero cost, Buffett has had to avoid underwriting losses – easier said than done. Insurance is a commodity business with pricing generally being the differentiating factor. But Buffett’s view was that even a commodity business can have a competitive edge if it has a cost base substantially below competitors. Buffett, therefore, either acquired insurance companies with such a competitive edge or, through better underwriting disciplines, good management and superior capital strength, developed the required competitive strengths.
Strong investment returns hugely strengthened the balance sheets of his insurance companies so that they could underwrite more business which provided an even greater “cash pool” and so on, creating a virtuous circle. His ability to pick great investments has meant that over the years the balance sheets of his insurance companies gained AAA ratings, further enhancing their ability to write business. Indeed, with AAA status, his insurance businesses gained a significant edge on competitors and one that was invaluable in difficult times. The over all result was that the “cash pools” in his insurance companies grew substantially benefiting both the Berkshire Hathaway insurance companies themselves and, in turn, the shareholders of Berkshire Hathaway, of which Buffett was the largest.
Identifying the Potential Long Term Winners
Buffett’s ability to pick great investments is the other part, and undoubtedly the most important part, of the Berkshire Hathaway success story. It never mattered to Buffett whether he was investing in public or private companies – his approach was the same.
The basic strength of Buffett’s investment approach has been his ability to pinpoint businesses capable of delivering well above average growth in earnings over the long term. He has always put 90 per cent of his efforts into determining the longterm earnings power of a company. Only when he understood this would he attempt to value the company. In contrast, the majority of investors (in the stock market at least) put 90 per cent of their efforts into interpreting present results.
Naturally, most people would copy Buffett’s approach if the task was easy – but it is not. To be able to pinpoint winning businesses on a longterm horizon is immensely difficult. Buffett has long recognised the difficulty of this task for himself. His solution has been to limit himself to investing in the few companies and industries he totally understands. As he says himself, he never invests outside his “circle of competence”.
The ‘Certainty Factor’
So what types of companies have provided Buffett with the required level of certainty of above average longterm earning growth? He starts by looking for companies that have a sustainable competitive advantage. This limits the competition and the threat of price erosion. Companies should also have a product or service that is needed or desired, is repetitively purchased by the customer and has no close substitute. These attributes ensure that the demand pattern for the company’s product is stable and continuous. A company should also be able to demonstrate an above average operating history and the longterm outlook for the industry should be favourable.
Buffett has found many of his opportunities in what he describes as consumer monopolies or franchises. All of the above traits are easily recognisable in his largest longterm stock market investments, which include The Washington Post, Geico, Coca-Cola, Gillette (now part of Proctor & Gamble) and Wal-mart among others. Of course, a good business must also be run by good management. According to Buffett, good management has three essential qualities – integrity, intelligence and initiative. He points out that if you don’t have the first, the other two are most likely to kill you.
The Washington Post & Coca Cola Purchases
In terms of a consistent operating history, the combination of a good franchise run by competent management should be evident in above average profit margins, high returns on capital and consistency of growth in earnings and cash flows in the past.
Enough of the theory – let’s examine two investments that Buffett has made in the past to see how the above worked in practice. In mid 1973, at a time when stock markets had just entered a difficult and protracted bear market, Buffett acquired an 8% holding in The Washington Post, whose shares had been sold off heavily as the market feared a downturn in advertising revenues during the sharp recession at that time. From Buffett’s viewpoint, the business was easy to understand. He could see a consumer product with no real substitute. Customers would continue to buy this newspaper every day irrespective of economic conditions. Buffett recognised the uniqueness of the brand which, over the longterm, virtually guaranteed a strong and growing advertising revenue base. He obviously judged management to be good and the company’s excellent longterm financial track recorded during the 1950s and 1960s was evident for anyone to see. So despite the fact that a weak advertising environment was putting pressure on profits at The Washington Post in 1973, Buffett recognised this to be a temporary issue.
In short, the weak economic and stock market backdrop provided Buffett with one of those rare occasions to buy a wonderful business at a knock down price. Berkshire Hathaway’s $11m investment has increased in value to $670m by end 2008, delivering Buffett and Berkshire Hathaway’s shareholders a compound annual return of 12.5% over the 35-year time frame.
His investment in the Coca-Cola Company is another illuminating example. Buffett invested a total of $1.3 billion for a 8.6% stake in Coca-Cola. Circa $1 billion was invested during 1988/89, a time when stock markets generally were in poor shape following the worldwide stock market crashes of late 1987. It was a significant move, as the Coca-Cola investment accounted for a significant proportion of Berkshire Hathaway’s net worth following the investment. Buffett saw a familiar profile; a company that could be easily understood, with a consumer product that undoubtedly had the best brand in the world. He added to the Coca Cola holding in 1994.
Again, the product was consumed regularly, ensuring repeat orders. On the strength of its brand, Coca Cola was able to sustain huge margins. In addition, the consumption of Coca-Cola in many regions of the world was still only a fraction of that in the US, which provided confidence that the Coca-Cola product could continue to expand volumes geographically for many years ahead. By end 2008, despite the lacklustre performance of Coca-Cola’s share price over the past several years, Berkshire Hathaway’s investment in Coca-Cola is worth $9.1 billion.
The rationale for the Gillette investment is almost a mirror copy of the Coca-Cola story. Buffett has remarked many times that he sleeps easy at night knowing that over 2 billion males have to shave in the morning – and many will use Gillette products. And other investments like American Express, Kraft Foods, Tesco, Johnson & Johnson mirror that thinking.
Having Your Cake & Eating It
The bear market during 2007-09 was particularly severe but Berkshire Hathaway entered it with piles of cash. During the dark days of September and October 2008, Buffett took the opportunity to invest $5bn into both Goldman Sachs and General Electric. Neither of these companies matched his previous attributes but he recognised the strength of their brands and limited his risk by buying ‘Convertible Preference Shares’ in both companies. These ‘Convertible Preference Shares’ provide Berkshire with an annual interest of 10% and are convertible into the equity at a point in the future which will allow Berkshire to also gain thr capital upside if or when these companies recover. It was a real case of both having your cake and eating it. The annual interest of 10% equals the long term returns on stock markets, so it was a better use of Berkshires cash. The option to convert into the shares of each company at some future time provided additional capital upside at the time of Buffett’s choice.