Warren Buffett on Intrinsic Value of a Company

          All the passages below are taken from the book by Robert G Hagstrom, “The Warren Buffett Way.”  The 3rd Edition was published in 2014.

 

In June 1984, I enrolled in a training program at Legg Mason Wood Walker in Baltimore, Maryland. For two weeks I listened to presentations on investing, market analysis, compliance, and selling techniques. I was expected to start my career as an investment broker soon, but I couldn’t shake the feeling that I had made a terrible mistake.

Legg Mason was a value shop, and its training program emphasized the classic works on value investing, including Benjamin Graham and David Dodd’s Security Analysis and Graham’s The Intelligent Investor. Each day, the firm’s veteran brokers would stop by and share their insights on stocks and the market. They handed us a Value Line Investment Survey of their favorite stock. Each company possessed the same attributes: a low price-to-earnings ratio, a low price-to-book ratio, and a high dividend yield. More often than not, the company was also deeply out of favor with the market, as evidenced by the long period the stock had underperformed the market. Over and over again, we were told to avoid the high-flying popular growth stocks and instead focus on the downtrodden, where the risk-reward ratio was much more favorable.

I understood the logic of the value investment approach; the math was not difficult. Value Line gave us an easy snapshot of a company’s balance sheet and income statement dating back 20 years. On top was a graph of the company’s stock price marching in lockstep with each year’s results. But no matter how many times I looked at a company’s spreadsheet, I felt something was missing.

On Thursday afternoon, the day before our training program ended, my instructor handed me a photocopy of a 1983 annual report from Berkshire Hathaway, a company I had never heard of, written by Warren Buffett, a guy I had never heard of. We were told to read the Chairman’s Letter and then be prepared to discuss it the next morning.

In my hotel room that night, I quickly thumbed through the Berkshire annual report and noticed, to my disappointment, there were no pictures or graphs. The Chairman’s Letter to shareholders, alone, was nearly 20 pages long. Resigned, I plopped down in my chair and began to read. It is hard to describe what happened next, but over the course of the evening, my entire view of investing changed.

For two weeks I had stared at numbers, ratios, and formulas, but now I was reading about companies and the people who ran them. Buffett introduced me to the 80-year-old Rose Blumkin, an immigrant from Russia who was generating $ 100 million in sales at Nebraska Furniture Mart. I became acquainted with Stan Lipsey, publisher of the Buffalo News, and Chuck Higgins at See’s Candies, and learned about the economics of running a newspaper and the competitive advantages of a confectionery business. Buffett then discussed the operating results of Berkshire’s insurance businesses, including the National Indemnity Company and the one-third interest in GEICO. But Buffett didn’t just rattle off the numbers; he walked me through the nuances of the insurance business, including yearly premiums written, loss reserves, combined ratios, and the tax advantages of structured settlements. If that weren’t enough, Buffett also gave shareholders an easy-to-understand tutorial on how a company’s intrinsic value could exceed its book value by the magic of economic goodwill.

The next morning I walked back into the training program, changed. The Value Line sheets with their endless string of numbers were still there, but those numerical skeletons had suddenly grown muscle, skin, and purpose. In a word, the companies had come alive. Instead of seeing just numbers, I began to think about companies, the people who were running the businesses, and the products and services that ultimately generated the numbers that filled a spreadsheet.

When I entered production the following week, I was filled with a sense of purpose. There was no doubt in my mind what I was going to do. I was going to invest my clients’ money in Berkshire Hathaway and in the stocks that Berkshire bought for its own portfolio. Each time Buffett would drop a breadcrumb, I would pick it up and buy it for my clients. If Buffett bought a stock, I would call the company, request its annual report, and study it intently, trying to figure out what he saw that others had missed. Before the advent of the Internet, you could send a check for $ 25 to the Securities and Exchange Commission and it would photocopy any annual report you wanted. I sent away for all the Berkshire Hathaway annual reports. Along the way, I collected all the newspaper and magazine articles written about Buffett. Anything and everything Buffett or Berkshire did, I would get a copy, read it, and file it. I was like a kid following a ballplayer.

A few years later, Carol Loomis wrote an article for Fortune magazine titled “The Inside Story of Warren Buffett” (April 11, 1998). Marshall Loeb, then managing editor of Fortune, thought it was time to write a full profile of Buffett, and he knew Carol was the perfect writer. Up until that time, the only inside look you could get about Buffett came from his Chairman’s Letters and his once-a-year appearance at Berkshire’s annual meeting in Omaha. But those who were aware that Carol Loomis also edited Berkshire’s annual reports knew that if anyone could write an inside story on Buffett she would be the one. I raced to the newsstand to grab what I was sure would be the last copy available.

Carol said she wanted to write a different type of story, one that emphasized Buffett not just as an investor but also as an “extraordinary businessman.” She did not disappoint. It was a beautifully written 7,000-word article that indeed gave the Buffett faithful a more intimate look at the man now dubbed the Wizard of Omaha. Carol gave us many insights, but none more ground-shaking for me than three little sentences tucked neatly inside the article.

 “What we do is not beyond anybody else’s competence,” said Buffett. “I feel the same way about managing that I do about investing: It’s just not necessary to do extraordinary things to get extraordinary results.”

Now I am sure many who read this chalked it up to Buffett’s Midwestern humility. Buffett is not a braggart. But neither does he mislead. I was sure he would not have made this statement if he did not believe it to be true. And if it were true, as I believed it was, it meant there was the possibility of uncovering a road map or, better yet, a treasure map that would describe how Buffett thinks about investing in general and stock selection specifically. This was my motivation for writing The Warren Buffett Way.

Reading Berkshire Hathaway annual reports for two decades, the annual reports of the companies Berkshire purchased, and the many articles written about Buffett helped me gain an understanding of how Buffett thinks about common stock investing. The single most important insight I gained was the knowledge that Buffett, whether he is purchasing common stocks or wholly owned businesses, approaches each transaction in the same way. Whether he is buying a public or a private company, Buffett goes through the same process, in more or less the same sequence. He thinks about the business, the people who run the business, the economics of the business, and then the value of the business, and in each case he lays what he learns against his own benchmarks. I labeled them investment tenets and divided them into four categories: business tenets, management tenets, financial tenets, and market tenets. The goal of The Warren Buffett Way was to take the major companies that Buffett had purchased for Berkshire Hathaway and discover whether they were, in fact, aligned with the tenets reflected in his writings and speeches. What would be valuable, in my opinion, and what would be valuable to investors was a thorough examination of his thoughts and strategies aligned with the purchases that Berkshire made over the years, all compiled in one source. To that end, I believe we were successful.

I had never met Warren Buffett before writing the first edition of the book. I did not consult with him while developing it. Consultation surely would have been an added bonus, but I was fortunate enough to draw from his own extensive writings on the subject of investing. Throughout the book I have employed extensive quotes from Berkshire Hathaway’s annual reports, specifically the Chairman’s Letters. Mr. Buffett granted me permission to use the copyrighted material, but only after he had an opportunity to review the book. However, this permission in no way implies that he cooperated on the book or that he made available to me secrets or strategies that are not already available from his writings. Almost everything Warren Buffett does is public, but it was loosely noted.

The principal challenge I faced in writing the book was to prove or disprove Buffett’s confession that “what [I] do is not beyond anybody else’s competence.” Some critics argue that, despite his success, Warren Buffett’s idiosyncrasies prevent his investment approach from being widely adopted. I disagree. Buffett is idiosyncratic— it is a source of his success— but I will argue that his methodology, once understood, is applicable to both individual and institutional investors alike. It is the goal of this book to help investors employ the strategies that I believe made Warren Buffett successful.

Still there are skeptics. The major pushback we have received over the years is that reading a book about Warren Buffett will not ensure that you will be able to generate the same investment returns that Buffett achieved. First, I never insinuated that by reading the book an individual could achieve the same investment returns as Buffett. Second, I was puzzled why anyone would think so. It seemed to me that if you bought a book about how to play golf like Tiger Woods, you shouldn’t expect to become Tiger’s equal on the golf course. You read the book because you believe there are some tips in the book that will help improve your game. The same is true of The Warren Buffett Way. If, by reading this book, you pick up some lessons that help improve your investment results, then the book is a success. Considering how poorly most people perform in the stock market, achieving some improvement will not be a herculean task.

Buffett and Charlie Munger, the vice chairman of Berkshire and Buffett’s intellectual sparring partner, were once asked about the possibility that their two great minds would educate a new generation of investors. That, of course, is exactly what they have been doing for the past 40 years. Berkshire Hathaway’s annual reports are famous for their clarity, absence of mumbo jumbo, and superb educational value. Anyone fortunate enough to attend a Berkshire Hathaway annual meeting knows how illuminating they can be.

Gaining knowledge is a journey. On his own journey, Warren Buffett took much of the wisdom of others, starting with Benjamin Graham and Phil Fisher. To that, he would add the many business lessons he learned from his partner, Charlie Munger. Collectively these experiences have helped shape a mosaic of investment understanding that Buffett, in turn, generously shares with others— that is, to others who are willing to do their own homework and learn all they can, with a fresh, vigorous, open mind.

At the 1995 Berkshire Hathaway annual meeting, Charlie Munger said, “It’s extraordinary how resistant some people are to learning anything.” Buffett added, “What’s really astounding is how resistant they are even when it’s in their self-interest to learn.” Then, in a more reflective tone, Buffett continued, “There is an incredible resistance to thinking or changing. I quoted Bertrand Russell one time, saying, ‘Most men would rather die than think. Many have.’ And in a financial sense, that’s very true.”

In the 20 years since I wrote The Warren Buffett Way, the noise in the stock market has continued to rise. And just when you think it can’t get any louder, it turns into a deafening screech. Television commentators, financial writers, analysts, and market strategists are over-talking each other, all vying for investors’ attention. The Internet is an information marvel. Everyone agrees. But it has also given free access, or should I say a free platform, to anyone with a financial opinion. As a result, we are all awash in financial advice.

Yet, despite an avalanche of information, investors continually struggle to earn a profit. Some are hard-pressed to even continue. Stock prices skyrocket for little reason, then plummet just as quickly. People who have turned to the stock market to invest for their children’s education or even their own retirement are bewildered. There appears to be neither rhyme nor reason to the market, only folly.

Far above the market madness stands the wisdom and counsel of Warren Buffett. In an environment that seems to favor the speculator over the investor, Buffett’s advice has proven, time and again, to be a safe harbor for millions of lost investors. Occasionally misaligned investors will yell out, “But it’s different this time!” and occasionally they will be right. Politics springs surprises, the economy reacts, and the stock market reverberates in a slightly different tone. New companies are born while others mature. Industries evolve and adapt. Change is constant, but the investment principles outlined in this book have endured. “That is why they are called principles,” Buffett once quipped.

 Here is a succinct and powerful lesson from the 1996 annual report: “Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now. Over time, you will find only a few companies that meet those standards— so when you see one that qualifies, you should buy a meaningful amount of stock.”

Whatever level of funds you have available for investing, whatever industry or company you are interested in, you cannot find a better touchstone than that.

 

Robert G. Hagstrom

Villanova, Pennsylvania

October 2013