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Title: SUPER INVESTING THE WARREN BUFFETT WAY


1
SUPER INVESTING THE WARREN BUFFETT WAY
Great Caesar's Ghost Kent, are you telling me I
can actually earn double digit returns?
Hey Lois, learn how to invest and you wont have
to worry about working at the Daily Planet the
rest of your life!
Yes Perry, thats right
Jeepers Superman you really can invest
Superman HELP the Market is falling!!!
2
Buffettology 101 The Wisdom of Warren Buffett
  • As far as I am concerned,
  • the stock market doesnt
  • exist. It is there only as a
  • reference to see if anybody
  • is offering to do anything
  • foolish.

  • Warren
    Buffett

3
Understanding the Influence of Ben Graham on
Warren Buffett Through the Story of Mr. Market
  • Long ago Ben Graham described the mental attitude
    toward market fluctuations that I believe to be
    most conducive to investment success. He said
    that you should imagine market quotations coming
    from a remarkably accommodating fellow named Mr.
    Market who is your partner in a private business.
    Without fail, Mr. Market appears daily and names
    a price at which he will either buy your interest
    or sell you his. Even though the business that
    the two of you own may have economic
    characteristics that are stable, Mr. Markets
    quotations will be anything but stable. For, it
    is sad to say, Mr. Market is a fellow who has
    incurable emotional problems. At times he falls
    euphoric and can see only the favorable factors
    effecting the business. When in that mood, he
    names a very high buy-sell price because he fears
    that you will snap up his interest and rob him of
    imminent gains. At other times he is depressed
    and can see nothing but trouble ahead for both
    the business and the world. On these occasions
    he will name a very low price, since he is
    terrified that you will unload your interest on
    him.

4
Ben Graham and Mr. Market Continued
  • Mr. Market has another endearing characteristic
    He doesnt mind being ignored. If his quotation
    is uninteresting to you today, he will be back
    with a new one tomorrow. Transactions are
    strictly at your option. Under these conditions,
    the more manic-depressive his behavior, the
    better for you.
  • But, like Cinderella at the ball, you must heed
    one warning or everything will turn into pumpkins
    and mice Mr. Market is there to serve you, not
    to guide you. It is his pocketbook, not his
    wisdom, that you will find useful. If he shows
    up someday in a particularly foolish mood, you
    are free to either ignore him or to take
    advantage of him, but it will be disastrous if
    you fall under his influence. Indeed, if you
    arent certain that you understand and can value
    your business far better than Mr. Market, you
    dont belong in the game. As they say in poker,
    If youve been in the game 30 minutes and you
    dont know who the patsy is, youre the patsy.

5
Who is Warren Buffett?
  • Warren Edward Buffett was born August 30, 1930,
    in Omaha, Nebraska. He is the son of Howard and
    Leila Buffett. Howard Buffett, a long-time
    resident of Omaha, was a local stockbroker and
    Republican congressman. As a boy, Warren Buffett
    was fascinated with numbers. He easily could
    keep track of mathematical calculations in his
    head. At age eight, Buffett began reading his
    fathers books on the stock market.
  • When Buffett lived in Washington, D.C., while his
    father served in Congress, his interests turned
    entrepreneurial. At age thirteen, Buffett worked
    two paper routes, delivering the Washington Post
    and the Washington Times-Herald. Back in Omaha,
    with his savings, he acquired reconditioned
    pinball machines for 25 each and placed them in
    local barbershops. Soon Buffett owned seven
    machines and was taking home 50 a week. Later,
    with a high school friend, Buffett bought a 1934
    Rolls Royce for 350 and rented it out for 35 a
    day. By the time he graduated from high school
    at sixteen, Buffett had saved 6,000.

6
Who is Warren Buffett?
  • While in his senior year at the University of
    Nebraska, Buffett read Benjamin Grahams classic
    book, The Intelligent Investor. This treatise on
    investing so influenced Buffett to the extent
    that, after receiving his college degree, he left
    his hometown of Omaha and traveled to New York to
    study with Ben Graham at the Columbia Graduate
    Business School. After graduating from Columbia
    with a masters degree in economics, Buffett
    returned to Omaha to serve a brief stint in his
    fathers brokerage firm. During this period,
    Buffett stayed in contact with his former teacher
    by writing to him about various investing ideas.
    In 1954, at Grahams invitation, Buffett moved to
    New York and joined the Graham-Newman
    Corporation. During his tenure at Graham-Newman,
    Buffett became fully immersed in his mentors
    investment approach.

7
Investment Wisdom
  • Dont try to buy at the bottom and sell at the
    top. This cant be done - except by liars.
    Bernard Baruch
  • Fools and greed usually go hand in hand, which
    creates a field of opportunity for the rational
    man.
  • Warren Buffett

8
Investment Wisdom
  • When it comes to risk, weve done better by
    avoiding dragons rather than by slaying them.
  • Warren Buffett
  • Traditional Wisdom can be long on tradition and
    short on wisdom.
  • Warren Buffett

9
Investment Wisdom
  • Investing is the greatest business in the world
    because you never have to swing. You stand at
    the plate the pitcher throws you GM at 47! U.S.
    Steel at 39! Coke at 48! And nobody calls a
    strike on you. Theres no penalty except
    opportunity. All day you wait for the pitch you
    like then, when the fielders are asleep, you
    step up and hit it.
  • Warren Buffett

10
Investment Wisdom
  • Buffett on Business Value We bought all of our
    Washington Post Co. holdings in mid-1973 at a
    price of not more than one-fourth of the then
    per-share business value of the enterprise.
    Calculating the Price/Value ratio required no
    unusual insights. Most security analysts, media
    brokers and media executives would have estimated
    WPCs intrinsic business at 400 to 500 million
    just as we did. And its 100 million stock
    market valuation was published daily for all to
    see. Our advantage, rather, was attitude We had
    learned from Ben Graham that the key to
    successful investing was the purchase of shares
    in good

11
Investment Wisdom
  • businesses when market prices were at a large
    discount from underlying business values. Most
    institutional investors in the early 1970s
    regarded business value as of only minor
    relevance when they were deciding the prices at
    which they would buy or sell. This now seems
    hard to believe. However, these institutions
    were then under the spell of academics at
    prestigious business schools who were preaching a
    newly fashioned theory The stock market was
    totally efficient, and therefore, calculations of
    business value were of no importance in
    investment activities. We are enormously
    indebted to those academics What could be more
    advantageous in an intellectual contest than to
    have opponents who have been taught that thinking
    is a waste of time.

12
Buffett on Growth and Value
  • Most analysts feel they must choose between two
    approaches customarily thought to be in
    opposition value and growth. Many
    investment professionals see any mixing of the
    two as a form of intellectual cross-dressing. We
    view that as fuzzy thinking in which, it must be
    confessed, I myself engaged some years ago. In
    our opinion, the two approaches are joined at the
    hip growth is always a component in the
    calculation of value, constituting a variable
    whose importance can range from negligible to
    enormous and whose impact can be negative as well
    as positive.

13
Buffett on Growth and Value
  • In addition, we think the very term value
    investing is redundant. What is investing if
    it is not the act of seeking value at least
    sufficient to justify the amount paid?
    Consciously paying more for a stock than its
    calculated value--in the hope that it can soon be
    sold for a still-higher price--should be labeled
    speculation which is neither illegal, immoral
    nor, in our view, financially fattening.
    Whether appropriate or not, the term value
    investing is widely used. Typically it connotes
    the purchase of stocks having attributes such as
    a low ratio of price to book value, a low P/E
    ratio, or a high dividend yield.

14
Buffett on Growth and Value
  • Unfortunately, such characteristics, even if they
    appear in combination, are far from determinative
    as to whether an investor is indeed buying
    something for what it is worth and is therefore
    truly operating on the principle of obtaining
    value in his investments. Correspondingly,
    opposite characteristics--a high P/E ratio, price
    to book and low dividend yield--are in no way
    inconsistent with a value purchase. Similarly,
    business growth, per se, tells us little about
    value. Its true that growth often has a
    positive impact on value. But such an effect is
    far from certain. For example investors have
    poured money into the domestic airline business
    to finance profitless growth.

15
Investment Wisdom
  • On Leaving Management Alone
  • At Berkshire we dont tell .400 hitters how to
    swing.
  • Warren Buffett

16
Warren Buffett on taking Your Time
  • An investor should act as though he/she had a
    lifetime decision card with just twenty punches
    on it. With every investment decision his card
    is punched, and he/she has one fewer available
    for the rest of his/her life. Warren Buffett

17
Warren Buffett-the Sage of Omaha
  • Buffetts Four Steps to Investing
  • 1. Turn off the stock market.
  • 2. Dont worry about the economy.
  • 3. Buy a business, not a stock. Change your
    perspective to that of a business owner and
    learn as much as possible about the business and
    industry.
  • 4. Manage a portfolio of businesses. Dont
    diversify for diversifications sake.

18
Buffett on Diversification
  • You cant be a Bo Jackson in investing. Spread
    your energies and your capital too many ways, and
    you are courting disaster. If you have really
    taken your time and only picked stocks that are
    bona-fide doozies, theres no need to diversify
    for safety. If youre not supremely confident
    about the future of each stock in your small
    portfolio, perhaps you should never have invested
    in it. Remember, the fewer stocks you have, the
    more time you can spend becoming an expert in
    them. You should never own more than ten stocks.
  • We dont believe in the Noahs Ark principle of
    investing, winding up with two of everything.
    Then you have a zoo.

19
Buffett on the Ideal Investor Personality
  • The most important quality for an investor is
    temperament, not intellect. You dont need tons
    of IQ in this business. You dont have to be
    able to play three-dimensional chess or duplicate
    bridge. You need a temperament that derives
    great pleasure neither from being with the crowd
    nor against the crowd. You know youre right,
    not because of the position of others but because
    your facts and your reasoning are right.

20
BERKSHIRE HATHAWAY INC.
Acme Brick Company Johns Manville Ben Bridge
Jeweler Jordan's Furniture Benjamin Moore
Co. Justin Brands Berkshire Hathaway
Group Larson-Juhl Berkshire Hathaway Homestates
Companies McLane Company Borsheim's Fine
Jewelry MidAmerican Energy Holdings
Company Buffalo NEWS, Buffalo NY MiTek
Inc. Central States Indemnity Company
National Indemnity Company Clayton Homes Nebraska
Furniture Mart CORT Business Services NetJets CTB
Inc. The Pampered Chef Fechheimer Brothers
Company Precision Steel Warehouse,
Inc. FlightSafety RC Willey Home
Furnishings Fruit of the Loom Scott Fetzer
Companies
Garan Incorporated See's Candies GEICO Auto
Insurance Shaw Industries General Re Star
Furniture Helzberg Diamonds United States
Liability Insurance Group H.H. Brown Shoe
Group Wesco Financial Corporation International
Dairy Queen, Inc. XTRA Corporation
21
Buffettology 101 - Learning NOT to Play the
Market
  • Dont be interested in the latest fades in the
    stock market.
  • The vast majority of investors, including mutual
    fund investors, are short-term oriented they buy
    on good news and sell on bad news. You should do
    just the opposite.
  • The short-term stock market mentality sometimes
    undervalues the long-term prospects of a great
    business.
  • Buy on bad news.
  • You must be able to grasp other peoples
    ignorance about the long-term economic worth of
    certain businesses.
  • Adapted from The New Buffettology, by Mary
    Buffett and David Clark, Chapter 1.

22
Buffettology 101 - Making Profits from Bad News
  • Practice a selective contrarian investment
    strategy. This is one in which the investor is
    motivated to invest by a falling stock price.
    Contrarians invest in what the market finds
    unattractive.
  • Recognize that the majority of investors play the
    short-term investment game.
  • People sell on bad news.
  • Companies that have a franchise product and thus
    a competitive advantage, have the economic power
    to weather most bad-news storms.
  • Always invest in companies with a long-term
    durable competitive advantage, which we call a
    franchise product. A product characterized by
    few or no substitutes, a product in demand by
    many, little or no government regulation.
  • Adapted from the New Buffettology

23
Buffettology 101 - The Interplay between
Profits and Inventory Turnover
  • The best kind of business to own is one with high
    profit margins and high inventory turnover.
  • The second best kind of business to own is one
    with either high profit margins or a high enough
    inventory turnover.
  • Stay away from a business with both low profit
    margins and low inventory turnover.
  • Stay away from commodity-type businesses such as
  • - Steel Producers - Airlines
  • - Gas and Oil Companies - Auto manufacturers
  • - Memory-chip producers - Paper manufacturers
  • Adapted from the New Buffettology.

24
Buffettology 101 - The Kind of Business to
Invest In
  • Focus on the competitive advantage and the
    durability of that advantage.
  • Competitive Advantage is created by producing a
    unique product or a unique service.
  • Examples Coca Cola, Harley Davidson, Wrigleys
    Gum.
  • Adapted from the New Buffettology

25
Buffettology 101 - Creating the Franchise Product
  • The Franchise Product has (is)
  • A Durable Product with a Competitive Advantage.
  • In high demand by a large segment of the market.
  • Little or no close substitutes.
  • Little or no Government regulation.
  • Adapted from the New Buffettology

26
Buffettology 101 - The Kind of Business to
Invest In
  • Durable means that the business must be able to
    keep its competitive advantage well into the
    future without having to expend great sums of
    capital to maintain it.
  • A low-cost competitive advantage is important for
    two reasons First is the predictability of the
    future earning power. Second, it improves the
    chances the business can expand shareholders
    fortunes rather than having to expend capital.
  • Adapted from the New Buffettology

27
Buffettology 101 - The Kind of Business to
Invest In
  • The key to investing is not to focus on how much
    a business is going to change society, but
    instead focus all your energy on determining the
    competitive advantage of the company and the
    durability of that advantage.
  • The two types of competitive advantage are
    created by producing a unique product and by
    providing a unique service.
  • The key is that the product or service have
    durability.
  • Some companies (Intel) have a competitive
    advantage based on intellectual talent and a
    large capital base, but manufacture products that
    have a short life span in the marketplace. These
    types of companies may have a competitive
    advantage, but they do not manufacture a product
    that has a durable competitive advantage.
  • Adapted from the New Buffettology

28
Buffettology 101 - Determining the Market Cap
  • The Market Cap represents the total capitalized
    value of a firm. It is obtained by multiplying
    the current market price of the firm times the
    number of share outstanding.
  • Suppose a company is currently selling at
    50/share and has 100 mil. Shares outstanding.
    The market cap would be 5 billion. If I require
    a rate of return of say 15, then this company
    would have to have earnings of 750 mil. What
    are the prospects for this?
  • Adapted from the New Buffettology

29
Buffettology 101 - Capitalizing on the Market Cap
  • If a business earned 100,000 per year, year
    after year, what would you be willing to pay for
    it? If you required 15 return you would be
    willing to pay 666,667. If your rate of return
    were higher, you would be willing to pay less for
    the company, and if your rate of return were
    lower than 15 you would be willing to pay more.
  • Lesson here is that higher interest rates make
    business earnings (and the business) worth less
    resulting in lower stock prices. Lower interest
    rates make business earnings (and businesses)
    worth more which results in a higher stock price.
  • Adapted from the New Buffettology

30
Buffettology 101 - Bull and Bear Market Cycles
  • When to Buy Stocks The buy side of the
    selective contrarian investment strategy is made
    up of two parts
  • The first step is to identify a company with a
    durable competitive advantage.
  • The second step is to identify the right price at
    which to make the purchase.
  • Market Cycles Certain types of markets,
    industry, and business conditions provide
    situations that provide buying opportunities for
    companies that have a competitive advantage.
    These conditions include market cycles, industry
    recessions, individual company calamities,
    structural changes, and war.
  • Adapted from the New Buffettology

31
Buffettology 101 - Bull and Bear Market Cycles
Bear Markets True Bear Markets devastate stock
prices across the board. They also offer the
possibility of terrific buying opportunities.
Once a Bear market is universally proclaimed
investors tend to over-react and become too
pessimistic, this is when opportunity comes
knocking. The bull market of the 1990s bubbled
in 1999 and burst in 2000, causing the bear
market of 2001. Bear markets appear
approximately every six years. The secret to
knowing when to invest is to be fearful when
others are greedy and greedy when others are
fearful. Key Point During a bear market it is
possible to find some spectacular buys on very
good companies with durable competitive
advantages.
32
Buffettology 101 - Bull and Bear Market Cycles
Transition from Bear to Bull A Bull market comes
to fruition after an economic recession and after
the bear market has devastated stock prices.
During a Bear market, many good stocks trade with
P/E ratios in single digits. Momentum investors
get killed in a bull market because they have
invested in stocks that had continued to go up
until the bear hits. A bear market also brings
back the general contrarian and value-oriented
investor. Money managers who follow this
strategy are hired by mutual funds to replace the
momentum investors who got killed when stock
prices sank. The Value investors often buy
stock for below book value. As the Fed begins to
lower interest rates, corporate earnings and
hence corporate caps begin to increase.
Investors and momentum investors see stock prices
rise and then jump in on the action, which starts
the cycle all over again. Adapted from the New
Buffettology
33
Buffettology 101 - Bull and Bear Market Cycles
The Bull Market Once interest rates are lowered
and stock prices increase, more and more
investors begin getting back into the market,
including mutual funds. Seeing spectacular
results in the neighborhood of 20 to 30,
investors respond by taking their money out of
low-interest, money-market accounts and start
buying mutual funds. The momentum
investor/mutual fund manager reappears in a big
way and begins the drama all over
again. Corrections and Panic Selling Then the
market suffers a correction (perhaps in October)
and goes through a short period of panic selling.
These provide perfect buying opportunities for
the selective contrarian investor. You must act
quickly and with great conviction to take
advantage of these opportunities.
34
Buffettology 101 - Bull and Bear Market Cycles
The Top of the Bull Market Bull markets can run
on for years. When stock market analysts and
media pundits proclaim that earnings are no
longer important in valuation, the bull market is
in its final phase. This is where it begins to
bubble. P/E ratios start going up from single
digits to the teens and then the twenties, then
thirties, forties, and fifties. Valuations are
now based on total sales and revenues instead of
P/E ratios. The result is that even businesses
that dont have earnings see their share prices
soar. Most recently it happened in the late
1990s. At this point the vast majority of fund
managers have been pushed into playing a momentum
game. The bubble is about to burst when you read
that value-oriented fund managers are quitting
the business because they cant compete with
momentum-fund managers. Adapted from the New
Buffettology
35
Buffettology 101 - Bull and Bear Market Cycles
The Bubble Bursts Rising interest rates, a shift
from earnings to revenue in valuations,
value-oriented fund managers being driven from
the game, and a split market in which some
industries get creamed and others continue to
soar spell impending disaster. If you are in the
hot segment, you should call it quits, sell out,
and go shopping in the unpopular segments. The
Aftermath After the bubble bursts, a couple of
things can happen. The first is recession. The
Fed will drop interest rates which take 12-18
months to begin reviving the economy. Do not buy
or sell stocks based on what you think the market
will do. Be a price-motivated investor. Adapted
from the New Buffettology
36
Buffettology 101 - Five Situations that
Create Buying Opportunities
  • Stock Market Correction or Panic
  • Industry Recession
  • Individual Business Calamity
  • Structural Changes
  • War
  • Adapted from the New Buffettology

37
Buffettology 101 - Five Situations that
Create Buying Opportunities
Industry Recessions An industry recession can
lead to serious losses or can mean nothing more
than a mild reduction in EPS. Recovery time is
normally 1-4 years. Dont be fooled by a selling
price that appears too cheap. Stay with a
well-capitalized leader, on that was very
profitable before the recession.Remember that the
market over-reacts to bad news and punishes
companies (good and bad) with lower stock
prices. Example The banking industry recession
of 1990 provided the opportunity to invest in
Well Fargo. Due to a recession in the real
estate market. Wall Street hammered Wells Fargo
stock down to 41.30 from 86. Wells Fargo lost
52 of its share price because it was not going
to make any money in 1991. Buffett bought 5
million shares, and by 2001 the price per share,
accounting for splits, was approximately 270.
Adapted from the New Buffettology
38
Buffettology 101 - Five Situations that
Create Buying Opportunities
Individual Calamity Sometimes brilliant
companies do stupid things and lose big money.
Most of the time the market will slam the stock
price. Your job is to figure out whether this
situation is a passing calamity or irreversibly
damaging. Example In 1999 Mattel acquired the
Learning Company. Mattel consistently lost cash
to the point that it sent the stock price from a
high of 46 a share in 1998 to a low of 9 in
2000. This created a buying opportunity since
Mattels main product line, Barbie, continued to
do an excellent business. Buffett bought Mattel
stock for 9-10. By the spring of 2001,
Mattels share price was at a healthy 18/share,
roughly returning 100. Adapted from the New
Buffettology
39
Buffettology 101 - Five Situations that
Create Buying Opportunities
Structural Changes Structural changes in a
company can often produce special charges against
earnings that have a negative impact on share
price. Mergers, restructuring, and reorganizing
costs can have a very negative impact on net
earnings, which translates into a lower share
price, which could mean a buying
opportunity. Examples Buffett invested in Costco
after it had suffered negative earnings due to
merger and restructuring costs. He also invested
in Tennaco Offshore and Service Master based on
these companies converting from corporate form
to a master partnership. Buffets investment in
Sears was based on the announcement that it would
spin off its insurance division, Allstate.
Adapted from the New Buffettology
40
Buffettology 101 - Five Situations that
Create Buying Opportunities
The War Phenomenon The threat of war will send
stock prices downward regardless of the time of
year.The uncertainty and potential for disaster
presented by any major armed conflict will kill
the market. The ensuing sell-off is strictly
motivated by outright fear, which results in
people selling stocks and hoarding cash, which in
turn, disrupts the economy. The 2001 war in
Afghanistan and the subsequent war in Iraq sent
stock prices tumbling and created fantastic
buying opportunities. Many industries such as
Airlines, car rental agencies, hotels, travel
companies, and cruise lines all saw their stock
prices decimated as a result of a massive
disruption of the travel industry. People simply
stopped traveling, for a while. There may be a
few permanent casualties, but there will also be
opportunity to buy good companies. You have to
do your homework. - Adapted from the New
Buffettology
41
Buffettology 101 - 4 Types of Companies with
Durable Advantage
1. Businesses that fulfill a repetitive
consumer need with products that wear out fast or
are used up quickly, that have brand-name appeal,
and that merchants have to carry or use to stay
in business. Examples of this would include
McDonalds Taco Bell, KFC, Campbell Soups,
Hershey Foods, Wrigleys, Coke, Anheuser-Busch,
Gillette, Levi Strauss, Nike, Liz Claiborne,
Harley Davidson. Adapted from the New
Buffettology
42
Buffettology 101 - 4 Types of Companies with
Durable Advantage
  • Advertising businesses, which provide a service
    that manufacturers must continuously use to
    persuade the public to buy their products. This
    is a necessary and profitable segment of the
    business world. Whether you are selling
    brand-name products or basic services, you need
    to advertise. Buffet examples include
    Interpublic, Ogilvy Group, Omnicom Group,
    Washington Post Company.
  • Adapted from the New Buffettology

43
Buffettology 101 - 4 Types of Companies with
Durable Advantage
  • Businesses that provide repetitive consumer
    services that people and businesses are
    consistently in need of. This is the world of
    tax preparers, cleaning services, security
    services, and pest control. Buffett examples
    include Service Master, Rollins, which runs
    Orkin, H R Block. Cintas Corp. rents uniforms,
    dust mops, entrance mats, etc., Dun Bradstreet,
    InfoUSA.
  • Adapted from the New Buffettology

44
Buffettology 101 - 4 Types of Companies with
Durable Advantage
  • Low-cost producers and sellers of common products
    that most people have to buy at some time in
    their life. This encompasses many different
    kinds of business from jewelry to furniture to
    carpets and insurance.
  • Adapted from the New Buffettology

45
Hersey Food's An Example
46
  • Doing the Analysis
  • Does Hershey have identifiable consumer
    monopolies or brand name
    products, or does it produce or sell a commodity
    product?
  • Do you understand how it works?
  • Is the company conservatively financed? In order
    to answer this consider the debt ratios. In the
    year 2000, Hershey had a total debt/total asset
    ratio of .75. This is high in comparison to the
    industry and to our threshold of 30.
  • Are the earnings of Hershey strong with an upward
    trend? EPS for Hershey has gone from 1.22 to
    2.39 from 1991 to 2000, a annual growth 7.

47
  • 5. Does the company allocate capital only to
    businesses within its realm of expertise? Answer
    here is yes.
  • Has the company been buying back its shares?
    Yes!
  • Does managements investment of retained earnings
    appear to have increased per share earnings and
    therefore shareholder value? Actually, during
    the last two years the Market Value Added was
    negative. However, over the last 10 years the
    MVA is 2.16 for every 1 retained.
  • Is the companys return on equity above average?
    Yes, over the last 10 years, Hershey has averaged
    26.4.

48
  • Is the company free to adjust prices to
    inflation? Hershey has adjusted prices and the
    size of its products over the years to
    compensate for inflation. People will not stop
    buying chocolate during inflationary time.
  • Are large capital expenditures required to
    constantly update the companys plant and
    equipment? No.

49
Buffets Tenets of Investing
  • 1. Is the business simple and understandable.
    Does the company have an identifiable durable
    competitive advantage?
  • 2. Does the business have an identifiable
    consumer monopoly or franchise product? What is
    the chance the product will become obsolete in
    the next 20 years?
  • 3. Does the business have a consistent
    operating history over time. Are earnings (net
    income) increasing and is the ROE consistently
    high (25-30).
  • 4. Does the business have favorable long-term
    prospects? Is it a franchise or least cost
    commodity producer? Look for Goodwill.
  • Invest within your circle of competence. Its
    not how big the circle is that counts, its how
    well you define the parameters. Warren Buffett
  • When management with an excellent reputation
    meets a business with a poor reputation, it is
    usually the businesss reputation that remains
    intact. Warren Buffett

50
Buffets Tenets (Cont.)
  • 5. Does the company allocate capital
    exclusively in the realm of its expertise?
  • 6. Is management rational? Does the management
    use excess cash to buy back stock and issue
    dividends, or expand company into low return
    investments. Does management express that they
    are committed to the best interests of the
    shareholders total return on investment.
  • 7. Is management candid with its shareholders?
    Does management do things the way that everyone
    else does or do they think and look at their
    environment before doing things?
  • Business schools reward complex behavior more
    than simple behavior but simple behavior is more
    effective. Warren Buffett

51
Buffetts Tenets (Continued)
  • 8. Does the Company have less than 30 debt?
  • 9. How much does the business have to spend on
    maintaining operations (check out operating
    ratios).
  • 10. Can the Company adjust prices during
    inflation?
  • Our favorite holding period is forever. --
    Warren Buffett
  • The Margin of error is the cornerstone of our
    investment philosophy Never count on making a
    good sale. Have the purchase price be so
    attractive that even a mediocre sale gives good
    results. - Warren Buffett.
  • A great investment opportunity occurs when a
    marvelous business encounters a onetime huge but
    solvable problem. - Warren Buffett.

52
Buffetts Tenets
  • 11. Focus on return on equity, not earnings per
    share. EPS is meaningless, since the equity base
    can expand over time due to increased retained
    earnings. Therefore, EPS does not necessarily
    reflect good managerial performance.
  • 12. Calculate owner earnings. Seek out
    companies that produce excess cash. Owner
    earnings is equal to net income plus
    depreciation, depletion, and amortization, minus
    capital expenditures necessary to maintain its
    economic position and unit volume.
  • Id rather have a 10 million business making
    15 than a 100 million business making 5. I
    have other places I can put the money. Warren
    Buffett
  • We like to buy Businesses, but we dont like to
    sell them. Warren Buffett

53
Buffetts Tenets
  • 13. Look for companies with high profit
    margins. Companies with tenacious cost-cutters.
    Remember companies with high costs will always
    come up with new ways to spend more.
  • 14. For every dollar retained, make sure the
    company has created at least three dollars of
    market value. Calculate the retained earnings
    to market value ratio (use a 10 year trend).
    Dollar created/Dollar retained.

54
Buffetts Tenets
  • 15. What is the value of the business? The
    cash flows of a business discounted back to
    todays present value determines the intrinsic
    value. Discounted by the long-term treasury rate
    plus 2 to 4 depending on your risk preference
    (Buffett uses 15).
  • 16. Can the business be purchased at a
    significant discount to its value? Look at the
    stock price. Can you purchase the stock at a
    significant discount to the stock price. The
    greater the difference, the greater the allowance
    for a margin of error. (At least 50).
  • It is far better to buy a wonderful company at a
    fair price than a fair company at a wonderful
    price. Warren Buffett

55
Buffets Tenets
  • Buffetts Yearly Check-up
  • - Calculate return on beginning shareholders
    equity
  • - Check the changes in operating margins, debt
    levels, and capital expenditures
  • - Check the companys cash generating ability

56
Financial Calculations Predictability of Earnings
  • Four types of Earning situations
  • 1. Consumer Monopoly Type Business
  • Year EPS
  • 2002 1.07
  • 2003 1.22
  • 2004 1.36
  • 2005 1.52
  • 2006 1.76
  • A Consumer Monopoly Type Business will have
    predictable earnings. Also check the growth in
    total earnings over the same time period.

57
Financial Calculations Predictability of Earnings
  • Four types of Earning situations
  • 2. Commodity Type Business
  • Year EPS
  • 2002 1.57
  • 2003 0.16
  • 2004 -1.28
  • 2005 0.42
  • 2006 -.023
  • A Commodity Type Business has earnings that are
    all over the place with no apparent trend. If
    something smells fishy it usually is.

58
Financial Calculations Predictability of Earnings
  • Four types of Earning situations
  • 3. Possible Consumer Monopoly
  • Year EPS
  • 2002 1.07
  • 2003 1.22
  • 2004 1.36
  • 2005 1.52
  • 2006 0.48
  • The Possible Consumer Monopoly appears to have
    strong consistent growth until 2006. Is this an
    aberration or a sign of things to come?

59
Financial Calculations Predictability of Earnings
  • Four types of Earning situations
  • 4. Possible Consumer Monopoly in Trouble
  • Year EPS
  • 2002 -1.07
  • 2003 1.22
  • 2004 1.36
  • 2005 1.52
  • 2006 -0.48
  • The Possible Consumer Monopoly may be in
    trouble.
  • The problem may stem from a one time problem
    that lands the firm out of favor on Wall Street.
    Check out the reasons for the negative returns.

60
Calculating the Initial Rate of Return
  • You must take a business perspective when
    investing. If you pay 25 for a share of stock
    and it earns 5, then your rate of return is
    5/25, which is equal to a 20 return. This
    calculation is the Return on Investment on Screen
    1 of the Excel Spreadsheets.

61
Calculating the Growth Rate in EPS
  • Use your calculator and the data below to
    calculate the growth rate
  • Year EPS
  • 2002 1.07
  • 2003 1.22
  • 2004 1.36
  • 2005 1.52
  • 2006 1.76
  • PV -1.07 FV 1.76 n 5 COMP i 10.5
  • Check out row 35 of Screen 1 on the Excel
    Spreadsheets

62
The Concept of an Equity/Bond with a Growing
Coupon
  • Warren Buffett views a stock as an equity bond
    that has a growing coupon. While most bonds have
    a fixed coupon, a stock can be viewed as a bond
    that has both a changing principal value and a
    growing coupon (net earnings) over time. But
    unlike fixed coupons on corporate bonds, stocks
    should be paying the holder a greater coupon
    payment each year the investor holds it. While
    the investor who holds the fixed bond receives
    his/her interest each year, the investor receives
    their earnings on a stock (usually in the form of
    dividends or increased stock price).

63
Using the Earnings growth rate to Project the
Companys annual rate of return
  • In the case of Johnson and Johnson from our excel
    spreadsheets, we have the following earnings
    values
  • 1996 1997 1998 1999 2000 2001 2002
    2003
  • 2,887 3,303 3,678 4,209
    4,800 5,885 6,811 7,197
  • To calculate the annual growth in earnings over
    this time period use your calculator
  • PV -2887 n 7 FV 7197 comp i 13.9

64
Why Stock Repurchase Programs Increase Investor
Wealth
  • Lets say that a company has 100 million shares
    and you own 10 million, which is 10 of the
    business. Lets say the company buys back 40
    million shares, it will have 60 million
    outstanding. Your ownership interest would be
    16.6 now (10/60). Now lets assume that the
    total CAP of the company is 800 million. Our
    original stake of the business would have been
    worth 80 million. Now, if the CAP remains the
    same, our stake is worth 132.8 million. The
    company has increased our net worth by 52.8
    million. Check line 14 of Screen 1 to see if
    your total number of shares outstanding is
    increasing or decreasing.

65
Measuring Managements Ability to Maximize
Retained Earnings
  • A consumer monopoly will always do a better job
    of getting a greater return on retained earnings
    than will a commodity type business. Therefore,
    you should always measure the firms return on
    its retained earnings based on the additional
    earnings that it generates over the analysis
    period. See line 58 of Screen 1 in the excel
    spreadsheets. Compare this rate of return to the
    value added on line 49.

66
Assignment
  • Read the Masters document on the Web site.
  • Begin looking for a company to analyze using the
    criteria given in class and the information in
    these overheads.
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