How to invest

Guest Post by

Daniel Sparks

Value Folio

Warren Buffett’s Berkshire Hathaway holdings (both subsidiaries and stocks) are all very different types of businesses. Consider these different industries which Berkshire has holdings in:

• Insurance
• Manufactured Homes
• Jewelry
• Fast Food
• Aviation
• Chemical
• Underwear
• Journalism
• TV Networks
• Furniture
• Banking
• Kitchenware
• Railroad

This list, of course, is only touching the surface.

Point being, Berkshire owns businesses in many different industries.

How, then, does Buffett still claim to stay within his “circle of competence”?

There must be some common factor among his holdings. As successful as Buffett has been during his investing career, the common factor should be regarded with great reverence. So what is it?

Many of you, I’m sure, have already guessed it. There is nothing complicated here. The answer is so simple that it almost seems like a waste of time. But perhaps there is power in simplicity.

This time, take a look at a list of actual businesses in Berkshire’s portfolio (subsidiaries and stock). The list is made up of many of Berkshire’s largest holdings:

• GEICO Auto Insurance
• Coca-Cola
• IBM
• American Express Co
• Burlington Northern Santa Fe Railroad
• Wells Fargo & Co
• Wal-Mart
• Procter & Gamble
• ConocoPhillips
• Dairy Queen
• Nebraska Furniture Mart

While I am sure it is possible to argue that there is more than one common characteristic between these businesses, the one screaming similarity is that they all have some sort of durable competitive advantage. None of these businesses would easily lose its competitive advantage overnight. Warren Buffett has clearly explained that he only invests in companies with an economic moat (his term for durable competitive advantage).

Recently, as Warren Buffett was justifying his $10 billion purchase of IBM stock, he used another word in place of economic moat. He explained that IBM has “continuity”. A close look at the definition shows a great resemblance to “economic moat” or at least it portrays the reason an economic moat is so necessary.

continuity: the unbroken and consistent existence or operation of something over a period of time

So for those of us Value Investors that are trying to emulate Warren Buffett, perhaps the most important question we could ask ourselves when considering our next purchase of a stock is

• Do the economics and competitive landscape of this investment allow for continuity?
• Does this business possess a wide and deep economic moat?

Answering this question, of course, is not easy. Two of the most common approaches include:

1. Looking for businesses that have higher gross margins than their competitors

2. Taking a good look at the business’ revenue stream, looking for (1) continuing demand, and (2) a promise of continuity. The best way to do this is to break down a business revenue stream by major products or services. Then you can get a better idea of where the revenue is coming from, how much demand there really is, and how sustainable it is.

Sometimes, however, just sitting back and thinking after you have done your research on the company might be your best option on deciding whether you think the competitive advantage is sustainable or not.

Warren Buffett and Charlie Munger have often said they spend much of their time simply thinking and reading. If the economic moat isn’t obvious, perhaps there is a good chance it doesn’t have an economic moat at all. That is at least the feeling I get when I look over Warren Buffett’s holdings.

About the author: Daniel Sparks is an MBA student at Colorado State University. He has a passion for value investing and runs a value investing blog at ValueFolio. He can be reached at danielsparks11@gmail.com

Guest Post by

Value Folio

I hate to crush anyone’s dreams but sometimes realism is simply a better catalyst for accomplishment than groundless euphoria. Let’s face it. You probably will never be like Warren Buffett. Unless, that is, you can read like a maniac.

Want to try to be Warren Buffett? When you wake up tomorrow morning grab a copy of Forbes and read it from front to back, followed by Wall Street Journal, Financial Times, New York Times, USA Today, Omaha World-Herald, and the American Banker (Crippen, 2007).

Crippen sums up the obvious: “Needless to say, he’s a fast reader.”

Still think you can be Warren Buffett? I didn’t think so. This daily reading list doesn’t even include the stack of SEC filings and annual reports he reads from front to back.

So let’s wake up and embrace our inferiority. Now a question stands right in front of us. If we can’t be Warren Buffett, can we still earn returns like Warren Buffett?

From 1965 to 2010 (45 years), Buffett’s Berkshire Hathaway shares have increased per-share book value at an average annual rate of 20.2% while the S&P 500 (with dividends included) has increased only 9.4% per year (2010, Berkshire Hathaway Annual Report).

This isn’t even including Buffett’s market crushing partnership returns before Berkshire Hathaway. His performance has been phenomenal and is simply unmatched. So the question remains: Can we earn market-crushing returns like Warren Buffett without being Warren Buffett?

Four Hour Investing

Perfection is achieved, not when there is nothing more to add, but when there is nothing left to take away -Antoine de Saint-Exuper

If Timothy Ferris, author of The Four Hour Work Week, were a value investor, I think he might believe achieving Buffet-like returns is possible.

For those of you who are Timothy Ferris fans (or haters) you know about his minimum effective dose (MED) philosophy. Ferris has dedicated the majority of his working life to putting forth the minimum effort for maximum results. Avid readers of his books, blog, and forum will conclude that Ferris is definitely on to something. In fact, I’ve been experiencing MED results first hand for the past month.

I’ve been implementing a compromised version of his Geek-to-Freak workout to put on some muscle on this awfully skinny body of mine the last 4 weeks. With only 2-3 workouts a week I’ve gained 7 1/2 pounds of muscle in 28 days–not bad for following the plan even with some compromise.

How does Ferris get more results out of less work? By working smart and not hard. Armed with hours of experimentation, trial and error, and the latest findings, Ferris is able to build on the work of others to accomplish just as much or more than others with less work.

This imposes a question for us value investors: Can we take the loads of investing information and plethora of investing services and tools and use them to our advantage, saving us time and labor? Can we earn Buffett returns by utilizing, disseminating, and interpreting the information that is provided to us by those who have already done most of the hard work for us?

Introducing: MED Investing

The modernization of the world and increased competition from a global economy is probably putting demands on your time. And, unfortunately, time doesn’t care about your problems. Time is unforgiving. You better learn to make the most of your time or you just might get left behind. As investors, therefore, we face a dilemma. We want to earn satisfactory returns on our hard earned money, yet what’s the point if it eats up all of our time? I think that it is time we consider MED (minimum effective dose) Investing. Is it possible?

I don’t have any hard facts for you about why (or even if) MED investing works, but, really, we have no choice but to give it a shot (unless you are Warren Buffett). So what weapons would the MED investor need in his or her arsenal?

1. Time management skills. If you’ve never read it, pick up a copy of Timothy Ferris’ The Four Hour Work Week. Though everything in the book might not apply to you, you’ll probably find some nuggets that will make your life much easier. My personal favorite? Baching.

2. Old School Value spreadsheets. Jae Jun explains the benefit of his spreadsheets with accuracy: “How would you like a full time stock analyst, working for you?” With OSV spreadsheets you can get the ratios and valuation methods you care about, all calculated for you in just a matter of seconds. OSV spreadsheets, combined with a basic understanding of value investing, will make investing much easier and save you an incredible amount of time. They are, without a doubt, the best valuation spreadsheets available.

3. Bloomberg Businessweek Magazine. Bloomberg Businessweek is published weekly. Its content is entertaining and, more importantly, will expand your horizons and business acumen, keeping you on the learning curve. The best way to better understand businesses is to read about them. Bloomberg Businessweek will keep you business savvy. Its cotent is completely relevant for investors. Good investors are voracious readers. You can’t go wrong here.

4. Motley Fool. If you haven’t joined this Foolish group of investors, I don’t know what’s stopping you. The Motley Fool Stock Advisor service pays for itself. Every month you’ll receive two new, thoroughly researched stock recommendations for your consideration, in addition to one of the best advisor newsletters ever to be published. The Motley Fool community is large and active. Motley Fool helps investors keep their heads on straight. If anyone focuses on the business as opposed to the stock, it’s Motley Fool. They have a reputation of buying great businesses and rarely selling. It’s a strategy that’s worked extremely well for them as they’ve crushed the market since inception.

5. Morningstar. Morningstar offers extensive financial information on stocks. It has brought all the information you need for an investment together in a user-friendly format, helping investors make better investment decisions. There is plenty of information available for free at Morningstar, including its star rating system of many stocks which can sometimes help give you confirmation in your investment choices. But their Premium membership is worth the money. This is another service that pays for itself. With the premium membership you have 10 years of financial data at your fingertips and Morningstar’s reports with Buffett-like analysis. Morningstar’s analysts take a fundamental approach and have done all of the hard work for you. These reports will not only help you get a better picture of a potential investment, but the analysts write in an educational manner, helping you improve your stock analysis skills. Plus, Morningstar Stock Investor Picks Have Beaten the S&P 500 during the last 8 years. If you don’t want to fork out the cash for a premium account, the free one is still fantastic.

Today I’m sitting in the Green Bean (the Starbucks of the desert) with my M-4 sitting at my side. As I look around, it looks like there are about 25 people with at least 4 different types of weapons in this coffee shop. All of us carry live ammo. We don’t know each other, but we trust each other. We trust each other with these weapons because we know that we all have had to train and become proficient with these weapons in order to carry them around like this. We’ve been schooled in accountability and watched those who dare do the wrong thing with their weapon experience serious punishment under the Uniform Code of Military Justice. The same goes with these investment tools. It is one thing to know they exist, but it is another to become proficient at using them.

I encourage you to take inventory of your arsenal. What do you have available at your fingertips? Are you effectively honing your investment weapons? When that opportunity comes you need to be ready to pull the trigger. On the other hand, you need to be well trained so you don’t commit fratricide.

Just as technology has made communication easier than ever, technology has presented investors with an opportunity to earn better returns with less labor.

So to answer our question, you don’t have to be Warren Buffett to earn Buffett-like returns. You only need to be the master of the information and tools at your fingertips.

Disseminate, filter, and utilize them wisely.

What weapons are in your arsenal?

Daniel Rudewicz

Furlong Financial

Before Warren Buffett became Chairman and CEO of Berkshire Hathaway, he ran a successful investment partnership. But his style of investing was not always the same, it gradually evolved over time. His high school jobs consisted of varied ventures including selling golf balls and delivering papers. The money he saved from these jobs was invested in the stock market using different investment styles.

Perhaps trying to find the best style for himself, Buffett had read every book related to finance in the Omaha Public Library by the time he graduated college.

His investment style up to this point was wide ranging. He had studied many different techniques including odd-lot investing and technical analysis.

Buffett’s Investing Framework Takes Shape

In 1950 he came across a copy of The Intelligent Investor by Benjamin Graham, his future mentor at Columbia. This book had a dramatic effect on Buffett’s investment style.

Graham’s investment style could be seen on a deeper level in his other book, Security Analysis, which was co-authored by David Dodd.

Within Graham’s two books, an investing framework was outlined that would shape Buffett’s stock selection for the rest of his career.

Graham favored looking at a stock as a piece of a business. He viewed volatility more as an opportunity and less as a risk.

Working for Graham

While also a professor at Columbia, Graham ran the investment partnership Graham-Newman Corporation. Through his investment partnership he invested using the Net Current Asset Value formula to identify companies. Using this formula he was able to find companies selling for below an estimation of liquidation value.

In the early 1950s, Buffet was piggybacking off of Graham’s ideas with his own money.

Through his partnership, Graham would sometimes buy large stakes in companies to influence managements and join the board of directors. Some examples include investments in Northern Pipeline, Philadelphia and Reading Coal & Iron Company, and Marshall-Wells.

It was at the Marshall-Wells annual stockholder meeting that Buffett first met Walter Schloss, whom he would later be colleagues with. It wasn’t until 1954 that Buffet finally convinced Graham to hire him at Graham-Newman.

There, Buffet worked alongside Schloss in a spare room manually computing the liquidation value of companies. A signature trait of this investing was that little time was spent evaluating management. Buffet and Schloss merely filled out simple forms which would be used by Graham to make his investment decisions.

By ignoring the qualitative side, Graham’s method was largely quantitative.

The Early Partnership

After the Graham-Newman partnership was closed in 1956, Buffet formed his own investment partnership. He employed many of the same methods that he used while working for Graham.

Buffet followed in his mentor’s footsteps by buying companies selling below liquidation value and then proceeding to influence management. He did this with success at Sandborn Map, Dempster Mill Manufacturing, and Berkshire Hathaway.

The Birth of Berkshire Hathaway

Berkshire Hathaway did not start out as the conglomerate it is today, but as a textile mill selling below liquidation value. Buffett first began buying it in 1962 and by 1965 he had taken control of the company’s board and made himself Chairman.

During this time, Buffett’s investing style began to change again.

While he still favored buying companies that were selling below intrinsic value, how he came to a company‘s intrinsic value began to change.

While still managing his partnerships, Buffett was introduced to Charlie Munger. Munger felt better about buying a great business with high returns on capital than buying a struggling company selling below liquidation value.

Buffett’s Investing Style Today

Over time, Buffett and Munger both began to move further from the strict Graham approach and more towards buying great businesses. By placing a greater emphasis on the intrinsic value as determined by the operating company’s future cash flows (rather than the company’s assets) a company’s qualitative characteristics became more important.

Buffett views Phillip Fisher’s book Common Stocks and Uncommon Profits as the best guide to successful qualitative investing.

By 1970, Buffett’s partnerships had been wound down and Buffett concentrated his efforts on running Berkshire Hathaway.

Over the past 40 years Buffett has been able to combine the quantitative style of Graham with the qualitative style of Fisher, and in doing so has become arguably the greatest investor of all time.

About the Author: Daniel Rudewicz is a CFA charter holder and the managing member of the deep value investment company Furlong Financial, LLC. He will begin attending Georgetown Law in the evenings this fall. To contact him please send an email to dan@furlongfinancial.com .

Daniel

Valuefolio.com

At my home we have a basic framework with which we view life and make decisions. This framework helps us to make sensible decisions without letting our emotions get in the way. Here is an example of two of the principles in the framework that my wife and I have developed over the course of our marriage.

1. Time is precious. This means that I don’t have time to sit around and cut coupons to save a few dollars. This time is better spent enjoying moments with my family. At our house there is no dollar value that will take me away from spending quality time with my family.
2. Face-to-face communication is valuable. We don’t play with our smart phones at the dinner table. We don’t answer calls when we are spending quality time with each other or with friends. We put our gadgets away when it is time to spend time together.

These principles guide decisions we make every day in my family. Similarly, a framework should be developed for investing.

Pat Dorsey, author of The Five Rules for Successful Stock Investing, claims,

Before you start investing you need to have a framework from which you make investment decisions. Without a solid framework it is easy to fall victim to psychological biases. (p. 1)

The first step to creating an investing framework is to develop a set of investing principles. I think every investor should take the time to develop a set of principles that are core to his or her investment strategy–principles they are proud enough to frame and put on their office wall. So after spending some time brainstorming, re-writing, re-wording, and re-thinking, I’ve finally came up with foundational principles for my investing framework:

These principles set the framework for every investment decision I make. If an investment doesn’t fit into this framework then there is no room for it in my portfolio, plain and simple.

I like to break rules, but even for rule breakers, a foundation is needed. Let’s define each principle.

1. Get your hands dirty: thoroughly research each investment before making an investment decision.
2. Demand a moat: Ensure the business has a durable competitive advantage
3. Leave room for error: Demand a large margin of safety. In other words, buy the business at a discount to its fair value.
4. Invest with conviction: Don’t make an investment unless you have a deep conviction about the investment potential.
5. Know when to sell: Decide at what point you would sell this investment and stick with your decision.

I encourage you to develop your own set of principles. Put them somewhere where you can see them. Make it look important. As Pat Dorsey said, this will save you from psychological biases. Who knows how many thousands of dollars something as simple as this could save you?

What are your investing principle? What makes up your framework? If your not sure, think about it like I did, write it down, and share it with us!

(This is a guest article by fellow value investor Daniel from ValueFolio.com. If you want me to post an article, contact me.)