By Dr. Jim Leontiades, Cyprus International Institute of Management
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You can’t beat the market. That is the view of most researchers who have studied stock markets in depth. So how is it that some investors have been able to do it? The most notable of these success stories is the famous Mr. Warren Buffett of Omaha. Having beaten the market consistently for many years, Warren Buffett is now one of the world’s richest men. He must have an advantage, an edge over the multitude of other institutional and private analysts attempting to do the same thing.
Warren Buffett makes no secret of his methods. His golden rule is to buy companies at a “discount to their intrinsic value”, that is, at a bargain price. Stated so simply, this is little better than advising investors to buy low and sell high.
However, there is much more to it than that. Buffett is noted for his careful, systematic analysis of the companies he buys. But many private and institutional investors can also claim to be careful and systematic. Perhaps even more important than the above are the things that Buffet does not do.
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— Buffett’s Don’ts
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Buffett does not believe in short term investments. He does not believe in following the Wall Street crowd or in listening to the many rumours and advice columns which bombard investors. The location of his office in Omaha, Nebraska, far from the spin of Wall Street no doubt helps. Once he has identified an attractive company he does not readily sell. He does not believe in the Wall Street saying that it is never wrong to reap a profit. Buffett does not believe in investing in businesses he does not understand. This explains why he missed out on the dot-com boom of 1999 while also missing out on the crash that followed. Most of his investments are in simple business models, eg. shoes, candy, jewellery, etc. Buffett does not invest in companies whose management he does not trust. He avoids companies that are not “shareholder friendly”, playing games with dividends. He does not invest in companies that do not have a consistent operating history, even if it means missing out on brilliant new startups.
Buffet does not believe in valuing companies according to price earnings ratios or dividend yields and other often used methods. He propounds the virtues of future discounted cash flow as his preferred method. Many would agree with this – but the devil is in the detail. How do you estimate future expected cash flow?
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— Buy and Hold
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Many of Buffett’s investments are in companies he acquires. The way Buffett carries out his research and acquisitions plays a major role in the superior performance of these investments. In assessing the worth of a firm, he takes an owner’s perspective of a company’s future worth. His strategy is “buy and hold”.
This may mean holding the equity for many years, even if the investment appears to be unattractive. He held one of his most successful investments (The Washington Post newspaper) for 17 years before it became profitable. This sort of patience is seldom found. Berkshire Hathaway, his holding company which manages his investment in many other firms, never really became successful in its initial textile business. It became worth billions only after many years when Buffett began using it as a vehicle for investing in other companies.
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— Buffett’s Acquisitions
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His acquisition focus is on companies that are large but not large enough (by American standards) to attract the attention of major institutions. Many are family firms, not listed on any stock exchange, hence below the scrutiny of most other investment analysts.
Because of his reputation the owners of many such firms who are interested in selling take the initiative, approaching Buffett with offers to sell all or a portion of their company. They are willing to open their books, offering the sort of detailed information difficult for other analysts to duplicate. His analysis of the firms’ management, their character, honesty and competence, is crucial information that is not always evident from written documents. Buffett talks to them personally and at length.
Although he offers a fair price, research has shown that the price of such firms is typically lower than the price of the larger firms whose shares are listed on the stock exchange and easily traded. This lower price is probably due to a lack of liquidity. Investments in such companies are typically difficult to exit and hence less attractive to potential investors.
However, once acquired by Buffett these companies become part of Berkshire-Hathaway, his holding company. They become part of a large, well known company whose shares are readily traded. Under the umbrella of Berkshire-Hathaway they lose their lack of liquidity and the discount that went with it. Their assets become more highly valued by the market.
In the final analysis Buffett’s edge is based on Buffett’s judgement in putting these various factors together.
