Investing like Warren Buffett

Dilip Gala, CFA Portfolio Manager, Nipra Financial Services Pvt Ltd

Who is Warren Buffett ?
• Warren Buffett is the world’s greatest living
investor and surely one of the greatest that’s ever lived, having compounded his money at an average of approximately 28% per year since 1950. • He is the second richest man in the world. • He is the Chairman of Berkshire Hathaway, Inc.

Who is Warren Buffett ?
• His company, Berkshire Hathaway’s
Per-Share Book Value has grown by CAGR 21.4% from 1965-2006 as compared to 10.4% growth in S & P 500 Index. • That means Overall Gain of 3,61,156% as compared to 6,479% of S & P 500 Index.

Investing like Warren Buffett
• According to Warren Buffett, there is no
fundamental difference between buying a business outright and buying shares in a business. • He looks for companies he understands, with favorable long-term prospects that are operated by honest and competent people and, importantly, are available at attractive prices.

Investing like Warren Buffett
• When he evaluates a potential
acquisition or stock purchase, Buffett works first and foremost from the perspective of a businessperson. He looks at the business holistically, examining all quantitative and qualitative aspects of its management, its financial position, and its purchase price.

Investing like Warren Buffett
• Step 1: Turn off the stock market. • Step 2: Don’t worry about the
economy. • Step 3: Buy a business, not a stock. • Step 4: Manage a portfolio of businesses.

Step 1: Turn Off the Stock Market
• Don’t allow the market to dictate your actions. • The market exists merely to assist you with the
mechanics of buying or selling shares of stock. • If you believe that the stock market is smarter than you are, give it your money by investing in index funds. • But if you have done your homework and understand your business and are confident that you know more about your business than the stock market does, turn off the market.

Step 2: Don’t Worry About the Economy

• No one has economic predictive powers

any more than they have stock market predictive powers. • If you select stocks that will benefit by a particular economic environment, you inevitably invite turnover and speculation. • Prefer to buy a business that has the opportunity to profit regardless of the economy.

Step 3: Buy a Business, Not a Stock
• Imagine you have to make a very important
decision. Tomorrow you will be given an opportunity to pick one business in which to invest. Also once you have made your decision, it can not be changed and, furthermore, you have to hold the investment for 10 years. What would you do? • If Warren Buffett were given the same test, he would methodically begin with the following principles, or tenets.

Business Tenets
• Is the business simple and
understandable? • Does it have a consistent operating history? • Does it have favorable long-term prospects?

Simple and Understandable
• You cannot make an intelligent guess about the
future of your business unless you understand how it makes money. • Too often individuals invest in stocks without a clue as to how a company generates sales, incurs expenses and produces profits. • If you can understand this economic process, you have the ability to intelligently proceed in your investigation.

Consistent Operating History
• If you are going to invest your
family’s future in a company, you will need to know whether the company has stood the test of time. • You should be assured that your company has been in business long enough to demonstrate an ability, over time, to earn significant profits.

Favorable Long-Term Prospects
• The best business to own, the one with
the best long-term prospects, is a franchise. A franchise is a business that sells a product or service that is needed or desired, that has no close substitute, and whose profits are not regulated. • The worst business to own is a commodity business.

Management Tenets
• Is management rational? • Is management candid with the
shareholders? • Does management resist the institutional imperative?

• Watch your company’s cash. How the
management reinvests cash earnings will determine whether you will achieve adequate return on your investment. • A rational manager will only invest excess cash in projects that produce earnings at rates higher than the cost of capital. If those rates are not available, the rational manager will return the money to shareholders.

Candor (Openness)
• Does your manager report the progress
of your business in such a way that you understand how each operating division is performing? • Does management confess its failures as openly as it trumpets its success? • Is the company’s prime objective to maximize the total return of their shareholders’ investment?

The Institutional Imperative
• Is your manager doing mindless,
lemming like imitation of other managers, no matter how irrational their actions may be. • One measure of managers’ competence is how well they are able to think for themselves and avoid the herd mentality.

Financial Tenets
• Focus on return on equity, not
earnings per share. • Calculate “owner earnings” to get a true reflection of value. • Look for companies with high profit margins. • For every rupee retained, make sure the company has created at least one rupee of market value.

Return on Equity
• Since companies continually add to
their capital base by retaining a portion of their previous year’s earnings, growth in earnings per share is really meaningless. • A true measure is return on equity, because it takes into consideration the ever growing capital base.

“Owner Earnings”
• Buffett seeks out companies that generate cash
in excess of their needs as opposed to companies that consume cash. • Accounting earnings need to be adjusted to reflect the cash-generating ability. • To determine owner earnings, add depreciation and amortization charges to net profit and then subtract the capital expenditures needed to maintain company’s economic position.

Profit Margins
• High profit margins reflect not only a
strong business but management’s determined spirit for controlling costs. • Also high margins are cushion in bad times.

The One-Rupee Premise
• Add the company’s retained earnings over
a ten-year period. Next, find the difference between the company’s current market value and its market value ten years ago. • If your business has been able to earn above-average returns on retained capital, the gain in market value of the business should exceed the sum of the company’s retained earnings.

Market Tenets
• What is the value of the business? • Can the business be purchased at a
significant discount to its value?

Determine the Value
• The value of a business is
determined by the estimated cash flows expected to occur over the life of the business, discounted at an appropriate interest rate. • The cash flows of a business are the company’s owner earnings.

Buy at Attractive Prices
• Once you have determined the value
of a business, the next step is to look at the price. • Buffett’s rule is, purchase the business only when its price is at a significant discount to its value. • Only at this final step does Buffett look at the stock market price.

Step 4: Manage a Portfolio of Businesses
• Now that you are a business owner as opposed to
a renter of stocks, the composition of your portfolio will change. • As a manager of a portfolio of businesses, you must resist the temptation to purchase a marginal company just because you have cash reserves. If the company does not pass your tenet screen, do not purchase it. • Be patient and wait for the right business. It is wrong to assume that if you are not buying and selling, you are not making progress.

Thank You