Critically assess the individual elements of Buffett's investment philosophy. Relate the elements to things you have come across in the finance core. Be very brief in your answers. Identify points with which you agree and disagree. Buffett's Investment Philosophy Warren Buffett was first exposed to formal training in investing at Columbia University in New York, where he studied under Professor Benjamin Graham. The coauthor of a classic text, Security Analysis, Graham developed a method for identifying undervalued stocks (1.e., stocks whose price was less than their intrinsic value). This became the cornerstone of the modern approach of value investing. Graham's approach was to focus on the value of assets, such as cash, net working capital, and physical assets. Eventually, Buffett modified that approach to focus also on valuable franchises that were not recognized by the market. Over the years, Buffett had expounded his philosophy of investing in his CEO's letter to shareholders in Berkshire Hathaway's annual reports. By 1995, those lengthy letters had accumulated a broad following because of their wisdom and their humorous, self-deprecating tone. The letters emphasized the following elements: 1. Economic reality, not accounting reality. Financial statements prepared by accountants conformed to rules that might not adequately represent the economic reality of a business. Buffett wrote: Because of the limitations of conventional accounting, consolidated reported eamings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers... Accounting consequences do not influence our operating or capital-allocation process.11 Accounting reality was conservative, backward-looking, and governed by GAAP. Investment decisions, on the other hand, should be based on the economic reality of a business. In economic reality, intangible assets such as patents, trademarks, special managerial expertise, and reputation might be very valuable, yet under GAAP, they would be carried at little or no value. GAAP measured results in terms of net profit; in economic reality, the results of a business were its flows of cash. A key feature of Buffett's approach defined economic reality at the level of the business itself, not the market, the economy, or the securityhe was a fundamental analyst of a business. His analysis sought to judge the simplicity of the business, the consistency of its operating history, the attractiveness of its long-term prospects, the quality of management, and the firm's capacity to create value. 2. The cost of the lost opportunity. Buffett compared an investment opportunity against the next best alternative, the so-called lost opportunity. In his business decisions, he demonstrated a tendency to frame his choices as either/or decisions rather than yeso decisions. Thus, an important standard of comparison in testing the attractiveness of an acquisition was the potential rate of return from investing in the common stocks of other companies. Buffett held that there was no fundamental difference between buying a business outright, and buying a few shares of that business in the equity market. Thus, for him, the comparison of an investment against other returns available in the market was an important benchmark of performance. 6. Diversification. Buffett disagreed with conventional wisdom that investors should hold a broad portfolio of stocks in order to shed company-specific risk. In his view, investors typically purchased far too many stocks rather than waiting for the one exceptional company. Buffett said: Figure businesses out that you understand, and concentrate. Diversification is protection against ignorance, but if you don't feel ignorant, the need for it goes down drastically. 18 7. Investing behavior should be driven by information, analysis, and self-discipline, not by emotion or bunch. Buffett repeatedly emphasized awareness and information as the foundation for investing. He believed that "anyone not aware of the fool in the market probably is the fool in the market. 19 Buffett was fond of repeating a parable told him by Benjamin Graham: There was a small private business and one of the owners was a man named Market. Every day Market had a new opinion of what the business was worth, and at that price stood ready to buy your interest or sell you his. As excitable as he was opinionated, Market presented a constant distraction to his fellow owners. What does he know?" they would wonder, as he bid them an extraordinarily high price or a depressingly low one. Actually, the gentleman knew little or nothing. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operation and financial position.20 Buffett used this allegory to illustrate the irrationality of stock prices as compared to true intrinsic value. Graham believed that an investor's worst enemy was not the stock market, but oneself. Superior training could not compensate for the absence of the requisite temperament for investing. Over the long term, stock prices should have a strong relationship with the economic progress of the business. But daily market quotations were heavily influenced by momentary greed or fear, and were an unreliable measure of intrinsic value. Buffett said: As far as I am concerned, the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses. You simply have to behave according to what is rational rather than according to what is fashionable.21 Accordingly, Buffett did not try to time the market (ie., trade stocks based on expectations of changes in the market cycle)his was a strategy of patient, long-term investing. As if in contrast to Market, Buffett expressed more contrarian goals: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."22 Buffett also said, Lethargy bordering on sloth remains the cornerstone of our investment style, 923 and "The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do. 24 Consider an opposing case, summarized in Exhibit 7. The example is similar in all respects except for one key difference: the annual return on the investment is 10%. The result is that every dollar invested buys securities worth $0.80. Thus, value has been destroyed. Comparing the two cases in Exhibits 6 and 7, the difference between value creation and destruction is driven entirely by the relationship between the expected returns and the discount rate: in the first case, the spread is positive in the second case, it is negative. Only in the instance where expected returns equal the discount rate will book value equal intrinsic value. In short, book value or the investment outlay may not reflect economic reality: one needs to focus on the prospective rates of return, and how they compare to the required rate of return. 4. Measure performance by gain in intrinsic value, not by accounting profit. Buffett wrote: Our long-term economic goal... is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. 14 The gain in intrinsic value could be modeled as the value added by a business above and beyond a charge for the use of capital in that business. The gain in intrinsic value was analogous to economic profit and market value added, measures used by analysts at leading corporations to assess financial performance. Those measures focus on the ability to earn returns in excess of the cost of capital. 5. Risk and discount rates. Conventional scholarly and practitioner thinking held that the more risk one took, the more one should get paid. Thus, discount rates used in determining intrinsic values should be determined by the risk of the cash flows being valued. The conventional model for estimating discount rates was the capital asset pricing model (CAPM), which added a risk premium to the long-term risk- free rate of return (such as the U.S. Treasury bond yield). Buffett departed from conventional thinking by using the rate of return on the long-term (such as a 30-year) U.S. Treasury bond to discount cash flows.15 Defending this practice, Buffett argued that he avoided risk, and therefore should use a risk-free discount rate. His firm used almost no debt financing. He focused on companies with predictable and stable earnings. He, or his vice chair Charlie Munger, sat on the boards of directors where they obtained a candid, inside view of the company and could intervene in managements' decisions, if necessary. Buffett wrote: I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn't make sense to me. Risk comes from not knowing what you're doing. 16 We define risk, using dictionary terms, as the possibility of loss or injury. Academics, however, like to define risk differently, averring that it is the relative volatility of a stock or a portfolio of stocksthat is, the volatility as compared to that of a large universe of stocks. Employing databases and statistical skills, these academics compute with precision the beta of a stockits relative volatility in the past and then build arcane investment and capital allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: it is better to be approximately right than precisely wrong. 17 6. Diversification. Buffett disagreed with conventional wisdom that investors should hold a broad portfolio of stocks in order to shed company-specific risk. In his view, investors typically purchased far too many stocks rather than waiting for the one exceptional company. Buffett said: Figure businesses out that you understand, and concentrate. Diversification is protection against ignorance, but if you don't feel ignorant, the need for it goes down drastically. 18 7. Investing behavior should be driven by information, analysis, and self-discipline, not by emotion or bunch. Buffett repeatedly emphasized awareness and information as the foundation for investing. He believed that "anyone not aware of the fool in the market probably is the fool in the market. 19 Buffett was fond of repeating a parable told him by Benjamin Graham: There was a small private business and one of the owners was a man named Market. Every day Market had a new opinion of what the business was worth, and at that price stood ready to buy your interest or sell you his. As excitable as he was opinionated, Market presented a constant distraction to his fellow owners. What does he know?" they would wonder, as he bid them an extraordinarily high price or a depressingly low one. Actually, the gentleman knew little or nothing. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operation and financial position.20 Buffett used this allegory to illustrate the irrationality of stock prices as compared to true intrinsic value. Graham believed that an investor's worst enemy was not the stock market, but oneself. Superior training could not compensate for the absence of the requisite temperament for investing. Over the long term, stock prices should have a strong relationship with the economic progress of the business. But daily market quotations were heavily influenced by momentary greed or fear, and were an unreliable measure of intrinsic value. Buffett said: As far as I am concerned, the stock market doesn't exist. It is there only as a reference to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses. You simply have to behave according to what is rational rather than according to what is fashionable.21 Accordingly, Buffett did not try to time the market (ie., trade stocks based on expectations of changes in the market cycle)his was a strategy of patient, long-term investing. As if in contrast to Market, Buffett expressed more contrarian goals: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."22 Buffett also said, Lethargy bordering on sloth remains the cornerstone of our investment style, 923 and "The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do. 24 Buffett scored the academic theory of capital market efficiency. The efficient markets' hypothesis (EMI) held that publicly known information was rapidly impounded into share prices, and that as a result, stock prices were fair in reflecting what was known about a company. Under EMH, there were no bargains to be had and trying to outperform the market was futile. "It has been helpful to me to have tens of thousands turned out of business schools taught that it didn't do any good to think," Buffett said.25 I think it's fascinating how the ruling orthodoxy can cause a lot of people to think the earth is flat. Investing in a market where people believe in efficiency is like playing bridge with someone who's been told it doesn't do any good to look at the cards.26 8. Alignment of agents and owners. Explaining his significant ownership interest in Berkshire Hathaway, Buffett said, I am a better businessman because I am an investor. And I am a better investor because I am a businessman.27 As if to illustrate this sentiment, he further stated: A managerial wish list will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market. 28 For four of Berkshire's six directors, over 50% of their families' net worth was represented by shares in Berkshire Hathaway. The senior managers of Berkshire Hathaway subsidiaries held shares in the company, or were compensated under incentive plans that imitated the potential returns from an equity interest in their business unit or both