How to assess investments like Warren Buffett: Tips from a Buffett-watcher

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People often choose individuals who are a lot like themselves to work with, and for, them. But, there's much to be said for picking a partner who has different, though complementary, skills and ways of thinking.  A prime example is the relationship between US investment guru Warren Buffett and his lesser known other half, Charlie Munger.

Last week Ian de Lange of Seed Investments offered some fascinating insights into how Charlie Munger sizes up investments in his blog published here on Biznews. Munger is very numbers-driven, and examines an investment possibility from many different angles. (For more on that read Inside the brain of Charlie Munger, Warren Buffett's investment partner.)

On the other hand, we always hear that Warren Buffett seems to take a cut-through-the-nonsense-and-keep-things-simple approach. This week, Ian's colleague Lourens Rabé elaborates on the types of questions Buffett considers before buying equity.

Lourens highlights some useful points that we should all consider when we choose an investment, like how much the return will be after tax. But Lourens' piece also  demonstrates the value of a partnership of two different thinkers.

Buffett and Munger are not peas in a pod. Where Charlie Munger is highly technically minded and gets into sophisticated terrain, Warren Buffett emphasises being practical and patient. – JC

How to assess investments like Warren Buffett: Tips from a Buffett-watcher

By  Lourens Rabé

Analyst Lourens Rabé unpacks Warren Buffett's investment skills. It all sounds so simple, yet few can emulate the Sage of Omaha's stock market success.
Analyst Lourens Rabé unpacks Warren Buffett's investment skills. It all sounds so simple, yet few can emulate the Sage of Omaha's stock market success.

Value investing the Buffett way: 1992 – 1997

"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 labelled speculation (which is neither illegal, immoral nor – in our view – financially fattening)."

Warren Buffett mentioned in his 1992 letter that when investing, practice does not make perfect but rather that practice makes permanent. It pays to be active, interested and open-minded when investing, but patience is essential. Instead of looking for fair businesses at good prices, rather take your time to buy good businesses at fair prices.

One should always be open to new ideas. Berkshire, for example, included holdings from the shoe industry in its portfolio, at that time Mr Buffett mentioned he probably would've never thought of it five years prior. It is again stressed to look at intrinsic value rather than book value. These two often diverge during the short run. Intrinsic value equals the present value of all future cash flows that can be taken out of a business during its remaining life, whereas book value includes retained earnings.

He sees "risk" as the possibility of loss or injury and not volatility, as it's widely defined (particularly in academic circles). "It is better to be approximately right than precisely wrong."

In his opinion, the real risk that an investor must assess is whether his after tax returns from an investment will match inflation over the prospective holding periods plus a modest real return on the initial stake. In order to achieve this, the principles to be evaluated include the certainty of:

  • economic characteristics of the business;
  • company management (to operate the business to its potential and to wisely employ its cash flows;
  • management that can be trusted to run the business to reward the shareholders rather than themselves;
  • the purchase price of the business;
  • the levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.

"You know it when you see it – you don't need complex equations or price histories."

Berkshire ignores political and economic forecasts, which are wrong most of the time, and has proven to be an expensive distraction for many investors and businessmen.  Buffett mentions that Berkshire usually makes its best purchases when apprehensions about some macro event are at a peak, "Fear is the foe of the faddist, but the friend of the fundamentalist."

He looks for managers that earn extraordinary returns from what appear to be ordinary businesses. His goal is then to acquire either part or all of the business that is understandable, has sustainable underlying economics, and is run by managers whom he likes, admires, and trusts. Before looking at a new investment one should consider adding to old ones. If a business is attractive enough to buy once, it may well pay to repeat the process.

Qualitative analysis is of immense importance, as seen in factors such as good corporate governance. "Directors should speak their mind and persuade other members for the greater good. The requisites for board membership should be business savvy, interest in the job, and owner-orientation. Not because they're prominent or add diversity".

Interestingly, in the late 1990s Mr Buffet makes his infamous concerns regarding tech companies. He exclaims the importance of a "margin of safety" that Ben Graham identified as the cornerstone of intelligent investing. He called himself a life-long sufferer from technophobia (admittedly Berkshire did start uploading their annual reports to the internet in the 1990s – but as a means of saving printing and distribution costs). He does not invest in tech stocks because he does not understand the business model – plain and simple.

It is evident from this report that Warren Buffett seeks to focus his time and effort on what he knows. This is his "circle of competence". Investors would do well to only invest where they have expertise and resist investing purely on the back of a 'good story'. At Seed we don't claim to 'know it all', but rather focus on our areas of expertise to provide solid inflation beating returns for our clients.

Lourens Rabé graduated from the University of Stellenbosch at the end of 2009 with BCom (Law) and studied further to complete BCom (Investment Management) in 2011. In  2012,  Lourens completed his BCom (Hons) in Financial Analysis and Portfolio Management at the University of Cape Town whilst working working as a junior investment analyst at Seed Investments.

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