Investment philosophy: Critically assess Buffetts investment philosophy. Identify the points where you agree and disagree with him.

Based on the case study:

Warren Buffett was first exposed to formal training in investing at Columbia University where he studied under Professor Benjamin Graham. A coauthor of the classic text Security Analysis, Graham developed a method of identifying undervalued stocks (that is to say, stocks whose prices were less than their intrinsic value). This became the cornerstone of modern value investing. Grahams 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 unrecognized by the market. Over the years, Buffett had expounded his philosophy of investing in his chairpersons letter to the shareholders in Berkshire Hathaways Annual Report. By 2005, those lengthy letters had accumulated a broad following because of their wisdom and their humorous, self-deprecating tone. The letters emphasized the following elements: 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 earnings may reveal relatively little about our true economic performance. Charlie [Munger, Buffetts business partner] and I, both as owners and managers, virtually ignore such consolidated numbersAccounting consequences do not influence our operating or capital-allocation process.9 Accounting reality was conservative, backward-looking, and governed by generally accepted accounting principles (GAAP), even though investment decisions 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 while in economic reality, the results of a business were its flows of cash. A key feature to Buffetts approach defined economic reality at the level of the business itself, not the market, the economy, or the securityhe was a fundamental analyst of the 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 firms capacity to create value. The cost of the lost opportunity. Buffett compared an investment opportunity against the next best alternative, the lost opportunity. In his business decisions, he demonstrated a tendency to frame his choices as either/or decisions rather than yes/no 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. Value creation: time is money. Buffett assessed intrinsic value as the present value of future expected performance: [All other methods fall short in determining whether] an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investments Irrespective of whether a business grows or doesnt, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.10 Enlarging on his discussion of intrinsic value, Buffett used an educational example: We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all important and is the only logical way to evaluate the relative attractiveness of investments and businesses. To see how historical input (book value) and future output (intrinsic value) can diverge, let us look at another form of investment, a college education. Think of the educations cost as its book value. If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education. Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didnt get his moneys worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.11 To illustrate the mechanics of this example, consider the hypothetical case presented in Exhibit 4. Suppose an individual has the opportunity to invest $50 million in a businessthis is its cost or book value. This business will throw off cash at the rate of 20% of its investment base each year. Suppose that instead of receiving any dividends, the owner decides to reinvest all cash flow back into the businessat this rate, the book value of the business will grow at 20% per year. Suppose that the investor plans to sell the business for its book value at the end of the fifth year. Does this investment create value for the individual? One determines this by discounting the future cash flows to the present at a cost of equity of 15%. Suppose that this is the investors opportunity cost, the required return that could have been earned elsewhere at comparable risk. Dividing the present value of future cash flows (i.e., Buffetts intrinsic value) by the cost of the investment (i.e., Buffetts book value) indicates that every dollar invested buys securities worth $1.23. Value is created. Consider an opposing case, summarized in Exhibit 5. 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. Value is destroyed. Comparing the two cases in Exhibits 4 and 5, the difference in 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 the economic reality. One needs to focus on the prospective rates of return, and how they compare to the required rate of return. Measure performance by gain in intrinsic value, not accounting profit. Buffett wrote: Our long-term economic goalis to maximize Berkshires 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. We are certain that the rate of per-share progress will diminish in the futurea greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.12 The gain in intrinsic value could be modeled as the value added by a business above and beyond the charge for the use of capital in that business. The gain in intrinsic value was analogous to the economic- profit and market-value-added measures used by analysts in leading corporations to assess financial performance. Those measures focus on the ability to earn returns in excess of the cost of capital. Risk and discount rates. Conventional academic 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 (e.g., 30-year) U.S. Treasury bond to discount cash flows.13 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 management decisions if necessary. Buffett once said, I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesnt make sense to me. Risk comes from not knowing what youre doing.14 He also wrote: 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 pastand 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.15 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 one exceptional company. Buffett said: Figure businesses out that you understand and concentrate. Diversification is protection against ignorance, but if you dont feel ignorant, the need for it goes down drastically.16 Investing behavior should be driven by information, analysis, and self-discipline, not by emotion or hunch. Buffett repeatedly emphasized awareness and information as the foundation for investing. He said, Anyone not aware of the fool in the market probably is the fool in the market.17 Buffett was fond of repeating a parable told to him by Benjamin Graham:There was a small private business and one of the owners was a man named Market. Every day, Mr. 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, Mr. 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.18Buffett used this allegory to illustrate the irrationality of stock prices as compared to true intrinsic value. Graham believed that an investors 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 doesnt 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.19Accordingly, Buffett did not try to time the market (i.e., 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 Mr. 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.20 Buffett also said, Lethargy bordering on sloth remains the cornerstone of our investment style,21 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.22Buffett scorned the academic theory of capital-market efficiency. The efficient markets hypothesis (EMH) 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 the company. Under EMH, there were no bargains to be had and trying to outperform the market would be futile. It has been helpful to me to have tens of thousands turned out of business schools that taught that it didnt do any good to think, Buffett said. I think its 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 whos been told it doesnt do any good to look at the cards.24 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.25 As if to illustrate this sentiment, he said: 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.26 For four out of six Berkshire directors, more than 50% of the family 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.27