Introduction

About the book

The book is based on the life of the greatest investor of all time, also known as the “Oracle of Omaha”, Mr. Warren Buffett. 

Buffett is an inspiration for most of the investors and students of finance. And this is for a reason. As we read through this book summary, we would realise that investing “is simple but not easy”. Buffett, although is regarded as a genius, still claims that investing does not require high IQ but high EQ or emotional quotient. How psychologically prepared we are in handling our money determines our investing success.

About the author

ROBERT G. HAGSTROM is a well-known author of financial books.   The Warren Buffett Way, one of his nine books, is a New York Times bestseller that explains the psychology of stock investing for readers around the world. Mr. Buffett is the greatest investor of all time, and this book helps readers comprehend it. 

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The book is a combination of mathematics and psychology learning which are essential for an investor. We highly recommend you to read the entire book. (affiliate link)

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A Five Sigma Event – The World’s Greatest Investor

Warren Buffett was born in Omaha, Nebraska on August 30, 1930. His family ran a grocery store and as a matter of coincidence, young Charlie Munger (the current business partner of Warren Buffett) was employed at Buffett’s grandfather’s grocery store. Warren was entrepreneurial, right from his childhood. As a gift he had received a money changer. With this in hand he went door to door selling chiclets, soda, magazines, popcorns, peanuts, etc. As the great depression hit, Warren’s father, Haward Buffett lost his job at a bank. However, little did Warren know, this hardship was a set up for him becoming the greatest investors of all times. After being jobless for some time, Haward started his own brokerage firm and this introduced Warren to the world of stock markets. Apart from luck, Warren’s sheer focus also contributed to his success. He focused on reading investing books right from his childhood.

At age 13, Warren moved to Washington with his family. His interest in entrepreneurship continued and he started delivering Washington Post newspapers door to door. Soon he saved some money and bought a paintball machine for $25 and installed them at a local barber shop. If looked closely it was such a strategic location as the waiting crowd at a barber’s shop often has nothing interesting to do. His first day return was $4. He even formed a company called, “Wilson Coin-Operated Machine Company” and expanded the business to 7 machines, taking home $50 each week. He was able to save $9,000 by the time he graduated from school. 

By 1950 after graduating from college, Buffett returned to Omaha and started to develop his old interest in the stock markets. However, this time he was more inclined towards price movement and focused on technical analysis. This continued till his eyes went on “The Intelligent Investor” a book authored by Ben Graham. He was massively influenced by this book and acknowledges that he still reads it over and over again. Buffett travelled to New York University to learn investing from Ben Graham. Buffett was an outstanding student in Graham’s class and was awarded A+, which was the first time in 22 years that Graham had been awarded. At a young age of 25, Buffett started an investment partnership in Omaha, managing family and friend’s money.

The Buffett PartnerShip Ltd. began with seven limited partners. In an investment partnership, there is one General Partner who is responsible for managing the money of other limited partners. Since the very beginning, he had set the expectations for the investors right. He told them that the motto of the partnership was to reduce the loss of capital and stocks would be chosen on the basis of value (value investing) and not popularity. His target was to outperform the Dow Jones Industrial Average Index by 10%. The partnership bought undervalued stocks chosen on the basis of Graham’s teachings.  He also engaged in merger arbitrage. This is a trading strategy in which stocks of two merging companies are bought and sold simultaneously to earn a (almost) riskless profit.

For example, Company A is merging with company B in the ratio, wherein each shareholder of company A would be getting 2 shares of company B. If company A is trading at INR 250 while B is trading at INR 100, the arbitrage would work by selling 1 share of company A at INR 250 and buying 2 shares of company B @100, thereby making an INR 50 profit.

Buffett's partnership, in its first five years, was up by 251% vs Dow Jones’ 75% return over the same period.

His first major investment was in American Express. In the 1960s there was an oil company which took loans on the basis of its Salad Oil inventory. As you know, oil floats on water, and therefore, the company took fraudulent loans on adulterated inventory from some of the major banks in the U.S. Out of these banks, American Express had lent $58mn. Since it was a scam and the entire money would be written off from the bank’s balance sheet, its share price dropped by 50%. Buffet had learnt from Graham that if the share price of a strong company falls, it needs to be given special attention. Hence buffet checked the records of card transactions and traveler’s cheques issued by American Express. He found out that these were unaffected and hence he made a decision to invest a massive 25% of the total partnership’s wealth into American Express stock. In the next three years, the share price of the bank tripled.

The market valuation had become crazy by 1969. That was the time when Buffett decided to liquidate the partnership money and return money to the investors. The target of outperforming the benchmark by 10% was beaten and Buffett outperformed the market by 22% annualized for the investing period of 12 years.

This was not the end for Buffett rather the beginning. Buffett had accumulated a massive $25 mn from the partnership. He was now looking for something else. Buffett accumulated a major share in a struggling textile company called Berkshire Hathaway.

The company was unable to generate a generous return on equity (return on equity is the return generated on the owner’s capital. Generally, a company that is able to generate a return on capital upwards of 18% is considered great, 12-18% is considered good while below 12% are considered gruesome). In business, a manager should always think rationally. If the economics of the business doesn’t allow it to earn a generous return on equity, it makes no sense to infuse capital into the business. Therefore, by 1985, Buffet closed the textiles business of Berkshire Hathaway ending a century old textile unit. He however, bought an insurance company under Berkshire Hathaway, with the cash flows the company had generated over the years.

The Education of Warren Buffett

Warren Buffett is said to possess the investing acumen of three legends, namely, Benjamin Graham, Philip Fisher and Charlie Munger. In this chapter, we will learn about the investment philosophies of all three.

Benjamin Graham

Graham is the pioneer of financial analysis. Prior to him, stock analysis was not structured and was not performed professionally. Two of his famous books “The Security Analysis” and “The Intelligent Investor” are world renowned. At age 25 in 1919, he was earning an annual salary of $6,000 (almost $8 million adjusted for inflation). By 1926, he went ahead to form an investment partnership with Jerome Newman and called it Graham-Newman. This was the same firm from which Warren Buffet started his formal investment management career later on. Graham-Newman survived the 1929 crash, the Great Depression, World War II, and the Korean War, before it was dissolved in 1956.

Graham faced financial ruin twice during his lifetime. The first one was when his father died leaving the family little savings. The second one was during the 1929 financial market depression. He is known for having a good memory and therefore was never able to forget the pain of financial ruin. In his investment philosophy as well, he kept a particular focus on not losing money.

Warren Buffett’s famous dialogue about the 2 rules to financial success, i.e. 

1. Rule no 1, Never lose money and 
2. Rule number 2: never forget rule number 1, was coined by Graham himself.

He also gave a formal definition to investment that distinguished between investment and speculation. An investment operation is a thorough analysis, which promises two things:

1. Safety of principal  
2. Satisfactory return. 

Operations not meeting these requirements are speculative.  

Let's break-up the definition to better understand the meaning of investing:

1. Thorough Analysis: Financial analysis is a three-step process-

• Descriptive: This involves collecting all the available facts of a company and presenting them in an intelligent manner.
• Critical: Examining the authenticity of the information collected.
• Selective: This involves judging the attractiveness of the stock. This is the most important step in financial analysis.

2. Safety of Principle: Return “of” capital is more important than return “on” capital. Therefore, select investments that are able to assure safety to the capital invested.

3. Satisfactory Return: This, according to Graham, is subjective. For one, 12% return can be satisfactory while for others even 25% return could be meager. Therefore, based on your analysis select stocks that are able to meet your investment return requirements.

The other contribution of Graham to the investment field was his method of choosing right stocks. His method involved buying while adhering to a Margin of Safety. 

1. Purchase stock when the overall market is trading at low prices (as indicated by a bear market)
2. Purchase a stock when it is trading below its intrinsic value. If the stock price is below its intrinsic value, then it is considered to be undervalued.

Intrinsic value is a subjective concept. Intrinsic as the name suggests is the true value of the company. This true value is determined by an individual based on its perception about the stock and the markets. Therefore, calculation of intrinsic value should be done individually by an investor.

As a simplified version of identifying stocks trading below intrinsic value, Graham suggests looking for companies that are trading below its net assets value. This although is quite reasonable, but it does not give adherence to qualitative aspects like management quality and brand value, etc. and therefore cannot be trusted.

Today, most investors rely on John Burr Williams ’s classic definition of value, as described in his book The Theory of Investment Value (Harvard University Press, 1938): The value of any investment is the discounted present value of its future cash flow.

Philip Fisher

Graham, who taught the investment world about quantitative investing, it was Fisher who emphasized on the fact that a lot of things are hidden in between the lines of the financial statements. Thus, it is not the ratio analysis alone that will help you select the right stocks, but “scuttle butt”. Suttle Butt is a technique of enquiring more and more about the company from people who have knowledge and information about the company and industry.

Fisher believed that in investing superior profits can be made by 

1. Investing in companies with above average potential
2. Investing in companies run by capable managements

In order to identify such stocks, Fisher looked at companies that were able to grow their sales and profits at a rate higher than the industry average. This trend should be looked at over several years. Both sales growth and profit growth are essential for a company’s success. Therefore, Fisher loved companies that were the lowest cost producers in the industry of operation. According to him, a company with a low break-even point and high profit margin is better able to sustain an economic depression.

Apart from this, Fisher also stressed on investing in companies which were run by management of unquestionable honesty and integrity. One way to judge this is by observing how the management communicates with the shareholders. Commonly, when times are good management may speak good things about the company to the shareholders whereas, they might disappear when times are bad. The employee retention and depth of the management team (talented management team) are also critical elements to judge the capability of the management team.

This can be a stressful process, therefore, Fisher focused on holding just a few outstanding companies and tracking them for really long periods of time. 

Charlie Munger

Charlie and Warren, although both were from Omaha and had a few mutual friends, had never met until 1959. It was only when Charlie moved back to Omaha on his father’s death, that a common friend thought of introducing the two. There was an instant connection between the two, as both were fond of common sense investing.

Charlie’s investment style was more of qualitative and less of quantitative. It can thus be said that he was more influenced by Philip Fisher and less by Ben Graham.

Warren, who was influenced more by Ben Graham, always wanted to buy companies that were available at cheap valuations based on conventional matrices like Price to Book <1. This however was not the most appropriate method to identify quality stocks especially when stocks are priced higher due to intangible off balance sheet items like brand value. 

Thus, when Buffett and Munger joined hands in Berkshire Hathaway, it was Munger who influenced Buffett to pay higher for quality stocks. The first instance of such investing was See’s Candy. 

See’s Candy was a Candy store, which was up for sale at a net price of $30 million. It was however quoting at 3 times its book value and hence Buffet was reluctant to overpay. It was then Charlie, who convinced Buffet to pay for quality and resultantly Buffet purchased See’s at a net price of $25 million. It was only 10 years later that they had got a quote of selling See’s Candy for five times their purchase price at $125 million.

Charlie’s investing style can be studied in depth in the book called, “Poor Charlie’s Almanac”. The Blend of Intellectual Influences. 

Buffett is supposed to be a blend of these three individuals – Ben Graham, Philip Fisher and Charlie Munger. All these three had a major influence on Buffet from time to time and shaped his investment philosophy. 

Graham's deep value approach of buying companies that were available below its book value was the basis of Buffett’s investment approach. However, with time Buffett realized that this methodology had been tweaked as when Graham devised this approach, it was a bear market and stocks were available at deep discounts to their book value. The methodology of valuing cheap stocks hence changed but what remained was the principle of Margin of Safety. This approach led Buffett to recognize stocks such as Coca Cola, Sees Candy and Intel, all of which were bought at prices higher than the net assets (book value) but possessed margin of safety. Graham also had taught Buffett to remain unemotional about the stock market fluctuations and instead take it as an opportunity. 

Philip Fisher on the other hand was quite different from Graham. While Graham was more concerned about the financial statements and quantitative characteristics of the company, Fisher looked for off-Balance Sheet items such as brand and management quality. He used to look ahead of the company's financial statements and instead spent time understanding the economics of the business. Fisher also stressed on the hazards of over diversification. Buffet as we know takes big bets on a single stock when he is confident. 

Remember American Express? He took a massive 25% of the total partnership money. Apple, his recent bet also makes up a significant portion of his overall portfolio. The concepts of Fisher were ingrained into Warren Buffet by the book “Common Stocks and Uncommon Profits” and his partner Charlie Munger. 

4 Principles: Buying a Business

Buffett does not distinguish between buying a business outright and owning a stock. As per Ben Graham, “Investing is most intelligent when it is most businesslike” This, according to Buffett, is the most thoughtful nine words in the history of financial analysis. Buffett, therefore, looks at investing in stocks with utmost due diligence, just like he owns a business. Of course, due to the sheer size of Berkshire’s cash balance, Buffett prefers to outrightly own a business rather than buying a portion of it, just because buying 100% of the company allows him to influence the decision-making and make the most important decision in the business – Capital Allocation.

Investing in the stock market is also fun. This is because some of the very large companies like Apple, owning 100% of which is not possible even for Buffett but are exceptional businesses. Additionally, the stock market, due to its volatile nature, can provide good entry points for investors. However, still while investing, Buffett’s views himself as a business analyst and not a market analyst. What is meant here is that he does not track the prices of the stocks; rather he understands the business model of the company and the management. Then he tries to estimate the future earnings and sustainability of the business.

In this chapter, the author has compiled four principles on which Buffett’s stock buying decisions are based. They are as follows:

1. Business tenets

• Business must be simple and understandable
  An important characteristic to choosing the right company is whether you are able to understand the business model of the company. It is therefore advisable to invest in companies that operate in simple and easy to understand business. That is why Warren loves his investment in banks, Coca- cola and See’s Candies.
• Business should have a well-run operating history
  Buffett does not like companies that are changing their business model every now and then. Successful companies such as Coca-Cola and American Express have been in the business of selling cold drinks and credit cards for ages and hence have mastered the game throughout the business cycles. It is more profitable to look at good businesses at a reasonable price than difficult businesses at cheaper prices.
• Business should have favorable long term survival prospects
  Buffett likes to own companies that sell products which are desired or needed, have no close substitute and are not regulated. These are the traits that provide companies with pricing power which is the ability to raise the prices of goods to maintain or improve profit margins. Pricing power provides companies with moat, a term coined by Buffet to define companies that have competitive advantages and are definite success stories for the long term. Buffett ignores companies that sell commodity products such as airlines, metals, etc. These generally do not possess pricing power.

2. Management tenets

• Is the management rational?
  The rationality of the management can be seen in its capital allocation decisions. Buffett, as we know, bought a textile company called Berkshire Hathaway. Due to the bad economics of the textile industry, it made little sense to deploy additional capital into the company. Hence, he instead changed the business model of the company altogether from textile to insurance and the rest is history. Similarly, good management should not deploy good money in bad projects (i.e. projects with low Return on Equity). If they do not find good avenues to grow the company, they should rather give money back to the shareholders by the method of dividend distribution and share buybacks. Good management will also not do aggressive acquisitions as acquisitions are seldom done at cheap valuations, hence destroying long term shareholder wealth.
• Management should be candid with the shareholders​​
  Management with high integrity should not hold on to any material facts from the shareholders. Good management is one that discloses its mistakes and bad decisions to the shareholders with the same enthusiasm that it describes its achievements. Like Buffett, who in his annual letter to shareholders, still laments some of the mistakes that he made decades back in order to remind shareholders that mistakes are a part of business; however, if the good decisions outrun the bad ones, the value will be created. Look for management who do not shy away from reporting bad quarterly numbers and events that are detrimental to future profitability.  
• Management should be able to resist institutional investors’ influence
  Big financial institutions such as SoftBank, Sequoia, etc., take big positions in a company. Because of the high percentage of ownership, they can influence the management of the company as well. Institutions in order to make quick gains, can influence the company to make big acquisitions, change business models or enter into trending business sectors. Good management is one which does not get influenced by these institutions and thinks independently.

3. Financial tenets

• Return on equity (ROE)
  Rather than concentrating on earning per share (EPS) growth, an investor should concentrate on the ROE of a company. ROE =Net Profit / Shareholder’s Equity.
  But why? Buffett considers there is nothing spectacular about a company that increases EPS by 10 percent if, at the same time, it is growing its earnings base by 10 percent. So, Buffett prefers return on equity—the ratio of operating earnings to shareholders ’ equity.
• Owner earnings
  An investor must make certain adjustments to the reported numbers of a company. For example, if there are any one-time gains/ losses (like gain on sale of an investment land/ loss in case of fire in a plant), etc. Additionally, the author has pointed out that depreciation is also an expense that should be considered while calculating the cash flows of the company (actually, he is talking about free cash flows). The author suggests that depreciation is an actual expense to a business, just like electricity and salary costs.
• High profit margins
  As preached by Philip Fisher, it is equally important for a company to grow its sales and profits simultaneously. Therefore, Buffet prefers to own companies with high profit margins. He believes in owning companies with the lowest cost base, as these are the ones that can command a higher margin in case of adversities. Management who have no control over the cost of the goods sold, are the worst management to be invested with.
• Every dollar retained should create at least one dollar of market value
  To judge the performance of the company, Buffett usually calculates the dollar return per retained earnings of the company. This concept is based on the belief that over the long term, markets will reward the companies with good capital allocation decisions and punish those with bad capital allocation decisions, How to calculate this?
  
  Simply add the retained earnings of the company that are available in the balance sheet for the last 10 years. Next see the difference in the market capitalization (share price x the number of shares outstanding) of the company over the last 10 years. Suppose, a company has retained 100 cr over the last 10-years while its market capitalization has grown by just 50 cr over the last 10-years. It does not pass Buffett’s test and hence should be avoided. On the other hand if the company has turned its market capitalization into 500 cr by retaining just 100 cr, it is the type of company that should be looked out for investing.

4. Market tenets

• Value v/s Price
  This relates to determining the value of a business. Buffett determines the value of the business via the concept of Discounted Cash Flow Analysis (DCF). Academically, DCF calculates the present value of all the future cash flows of a company at an appropriate discount rate. Therefore, this method has two important tasks.
  
  Firstly, by understanding the economics of the business in depth, an investor should be in a position to forecast the earnings of the company for future years. Secondly, the earnings forecasted should be discounted at an appropriate discount rate. Now, this discount rate as per economists in the risk-free rate + equity risk premium. Risk-free rate as the name suggests is the rate of return that can be earned without taking any risk. For simplicity, let’s assume this as the return of a government bond. An equity risk premium is the premium that an investor demands taking extra risk than the government bond. Here, Buffett differs from the academicians. He states that when he is buying a company with best-in-class management and is certain about the sustainability and growth of the business, why to consider this extra risk? Hence for him, the appropriate discount rate is the risk-free rate. Of course, in practicality he either adjusts the interest rate either when he feels that government bond yields are too low (as happened during the coronavirus period, when some of the interest rates were negative) or keeps a margin of safety. The margin of safety, in simple terms, is buying the shares at a significantly lower price than the value arrived via the DCF analysis.
  
  For example, if Buffett calculated Apple’s value at $400 via DCF, however the share price currently is $350. In this case, he might pass the buying decision as there is a very low margin of safety. He might be interested in buying the stock when it falls to $200.
• Can the business be purchased for a substantial fraction of what it is worth?
  This relates to the concept of “margin of safety”. The higher the margin of safety the safer is the investor. Therefore, Buffett concentrates on companies that are run by able management and earn high RoE and are available at a significant discount to its value (as calculated via DCF) thereby getting a margin of safety. In case of a market crash, either these companies will fall less or will be a buying opportunity for investors at lower and more attractive prices.

Buffett's Investments: The Washington Post

In this chapter the author has compiled 9 stock stories and teaches us how Warren Buffett looked at each of them as investment ideas. This is probably the most important chapter of the book as the case studies from this chapter can be used by us in our investment analysis. As we read through this chapter, we will understand various traits that were common in each of the companies that Buffett invested in. Also, each of the case studies is divided into the 4 tenets as described in the previous chapter to better understand why Buffett invested in these companies. We have divided this chapter into separte section for each stock. Strating with the first one:

The Washington Post 

Buffett bought the Washington Post during the bear market of 1973. However, the owners then of the Washington Post were not comfortable with an outsider buying such a large stake in the company. Since the beginning of his ownership journey, Buffett does not have a reputation for influencing the company or for a hostile takeover. He likes to work in harmony with the management and hence he assured the promoters of the Washington Post that he would not take part in the day-to-day operations of the company even if he held a majority stake. Let’s now look at why Warren bought the Washington Post via the tenets of his investing style.

1. Simple and understandable business

Prior to owning the Washington Post, Buffett owned a few other weekly journals. His grandfather owned and operated a weekly newspaper. This taught him about the newspaper industry. Although he was a supporter of high-quality journalism, he, however, looked at the Washington Post as a profit-generating machine.

2. Consistent operating history

Buffett was involved in the distribution of the Washington Post during his childhood days when he used to do petty jobs in order to earn pocket money. Thus, the Washington Post has been in business for a long time.

3. Favorable Long-Term Prospects

Buffett believes that the prospects of a dominant newspaper are excellent. In the 1980s, prior to internet adaptability, there were some 1,700 newspapers in the U.S. and 1,600 operated without any direct competition. Owning a newspaper, according to Warren, was like getting royalty through the advertisement of any business that ran in town. Newspapers also have low capital requirements and have pricing power due to distribution moat.

4. Determine the value

The author had derived the value of the Washington Post during the time when Buffett bought it in 1973. He has used the DCF methodology although with a twist. At the end of 1972, Washington Post had a net income of $13.3mn + Depreciation ($3.7mn) – capital expenditure ($6.6mn) = $10.4mn divided by the long-term US government bond yield of 6.81%, giving a value of $150mn. Whereas, Washington Post was available at a valuation of just $80mn in 1972. Hence it was a good buy.

A catch here with the author’s calculation is that he has not estimated the future earnings of the company. Rather he has assumed that there will be no growth in the company’s earnings in the future and that the company will keep on earning $10.4mn for perpetuity. This is a very simplified version of DCF which cannot be used in the practical world as companies face fluctuation in their profits due to business cycles.

5. Buy at attractive prices

As calculated from the above DCF methodology, Washington Post was available at almost half the value and hence was an attractive buy for Warren Buffett.

6. Return on Equity

Washington Post had a return on equity (ROE) of 15.7% when Buffett purchased the stock. This was moreover an average ROE. Over the next ten years since his investment, the ROE shot up to 36% which is supernormal.

7. Profit Margins

The profit margins of the company in the 1960s were 15%, however the company faced the challenge of high wages as there were unions in the press. This led to a sharp drop in the margins to 10.8%. However, the company was able to solve the issue, and by 1988, the pre-tax margins jumped to 31.8%, higher than the 16.9% average margin of the U.S. newspaper industry and 8.6% margin of S&P Industrial Average stocks.

8. Rationality

A rational management is one which participates in efficient capital management. In case of the Washington Post, Buffett was able to convince the management that the change from newspaper to online/ television was a secular change and hence the pricing power of the industry was going to be affected. Hence the company participated in large buybacks and dividends to reward its shareholders. Additionally, Buffett did not sell its holding in the Washington Post even though he was convinced of the secular change, because the company held $400mn in cash holdings and was effectively debt free.

9. The One-Dollar Promise

If the management has optimally invested the capital, then the same is reflected in the gain in the market capitalization of the company over the long term. For the Washington Post, between 1973-1992, it had retained $1.46bn. From 1973-1992, the company gained $2.55bn in market capitalization. Hence, the company was able to create $1.81 in market value for each dollar retained. 

Buffett's Investments: GEICO Corporation

Government Employees Insurance Company (GEICO) was a special type of insurance company that used to sell motor insurance to government employees. The founder of the company had discovered that government employees are safe drivers and hence its profitable to sell insurance to them as the claims are lower. Additionally, GEICO used to sell insurance directly to customers, thus eliminating middle men. This helped the company save 10-25% of the cost compared to other insurance companies that sold policies through agents.

GEICO was running profitably; however, post the management change it faced a lot of difficulties specially related to underfunded balance sheets. This means that the company had lower assets than the claims it needed to settle. Thus, the share price which had hit a high of $61 in 1972, stood at $2 in 1976. Buffett invested $4.1mn into the stock at an average price of $3.18 when it was close to bankruptcy. Let us find out what made Buffett buy such a loss-making company.

Simple and understandable

Buffett was fond of insurance companies and held insurers such as Kansas City Life, Massachusetts Indemnity and Life Insurance Company and National Indemnity in Berkshire’s portfolio. The CEO of National Indemnity educated Buffett on how an insurance company is run. Thus, despite GEICO’s shaky financials, Buffett was able to invest in the company because he knew the business well.

Consistent operating history

Although, 1975-1976, GEICO performed poorly, but the understanding of the economics of the insurance business made Buffett conclude that the company was just wounded and could turnaround. The low-cost operations of the company achieved through selling insurance directly to the customers created a moat and hence was a special business to own.

Favorable long-term prospects

Although, insurance is a commodity business, with no price differentiation. However, Buffett has always believed that low-cost is a moat and hence for a commodity business, having a low-cost operation is a must.

Rationality

When the company was facing financial losses, the CEO at that time, Jack Byrne, made a tough decision to slow down the growth and work on profitability first. The efforts paid off. 

In 1976, when the company was facing financial difficulties and required money for operations, it stopped dividends. Next, in 1983, the company was not able to invest the surplus cash at higher returns. It increased the dividends and returned the money to shareholders by way of buybacks.

Return on Equity

In 1980, the ROE was 30.8%, twice as high than its peers.

Determining the value

In 1980, Buffett owned a third of GEICO. It earned a net profit of $60 million. So, Berkshire’s share in the earning would be 60/3 = $20 million. Buffett was of the view that to buy a $20 million earning business with similar quality, one was ready to pay $200 million. And do you know at what price Buffet acquired 1/3 of GEICO or at what price Buffett acquired the business giving him $20 million annually? It was at just $47 million. That is a huge margin of safety.

The One-Dollar Premise

Between 1980 to 1992, GEICO’s market cap rose from $296 million to $4.3 billion. During these 13 years, it retained $1.4 billion. Hence it created a value of $3.12 for every dollar retained. 

Buffett's Investments: The Coca-Cola Company

The Coca-Cola investment is very close to Buffet's heart. He made the investment at 5x book value and 15x earnings, which was above the average market valuation during that time. Buffett had spent about $1.02 billion to acquire a 7% stake in the company, which was the largest investment ever made by Warren Buffett.

Simple and understandable business

Coca-Cola is the simplest business to own. The company manufactures bottled soda and distributes it throughout the world. The company sees itself as distributing happiness and has immense admiration throughout the world for its products. The company also  provides soft drink syrups to quick service restaurants and movie halls that in turn sell them to their customers at a higher price.

Consistent operating history

The company started in the year 1886. 137 years later, the company is still selling the same product + numerous other products. There has been significant growth in the company’s size and geographic reach during the period. 50 years after its inception, the company was selling 207 million cases of soft drinks “annually” while today it is selling 1.7 billion cases “daily”. Nothing matches the distribution and consistency of Coca-Cola.

Favorable long-term prospects

Although Buffett knew about Coca-Cola since his childhood, however, he purchased it in the 1980s because of the favorable changes that were happening in the company under the leadership of Roberto Goizueta (Chairman and CEO) and Donald Keough (President).

The 1970s was a difficult time for Coca-Cola. They were: 

1. Dispute among distributors
2. Federal Trade Commission charged the company with violation of the Sherman Antitrust Act (prohibits activities that restrict interstate commerce and competition in the marketplace)
3. International business in Arab, Israel and Japan is slowing down.
4. Quality issues in the Japanese market
5. Unrelated diversification
6. Low employee morale

Then came Roberto Goizueta. He encouraged teamwork and one of the first tasks was to bring all 50 managers together and ask them “what was being done wrong in the company”. In this meeting the company constructed a 900-pager pamphlet called “Strategy for 1980s' ' outlining the corporate goals for Coca-Cola.
He began cutting costs and optimizing return on assets. This translated into higher profit margins for the company.

High profit margins

In 1980, the company earned a pre-tax margin of 12.9%. In Goizueta’s first year it grew to 13.7% due to his cost optimization measures and finally in 1988 when Buffett purchased his shares, the pre-tax margins stood at 19%.

Return on equity

As a major step of his strategy, Goizueta divested any business that was not generating an acceptable ROE. Also, any new business that the company would enter should have the potential to generate real growth. Growth can be of two types, one that is based on intrinsic growth, i.e. through quantity (real growth) and the other which is based on price increases (inflation). One that is based on volume growth is more sustainable growth. By 1988, Coca-Cola had generated an ROE of 31%.

Rational management

While Coca-Cola increased the dividends per share, it also initiated a buyback program in order to increase the ROE of the company. ROE is basically, Net Profit divided by the Equity of a company. When a company buys back its shares, the equity of the company falls and hence the denominator (equity in this case) decreases. This leads to a higher ROE.

Institutional imperative

Goizueta was focused on increasing the ROE of the company. Divesting unviable yet exciting businesses like vineyards was a bold move. He took actions on time and was not concerned about the institutional ownership in the company and was concerned about the retail investors. It signifies his unwavering focus on business and ROE generation.

Buffett's Investments: General Dynamics

The company was the second largest defense contractor in the U.S. in the year 1990. Buffett purchased General Dynamics in 1992.

Institutional imperative

Anders, the CEO of the company in 1992 had realized that the company cannot diversify in non-defense businesses and even in defense products, the company needs to be in products that have franchise-like products and could achieve critical balance between research and development and production capacity. The rest of the business would be sold off. In less than 6-months the company raised $1.25 billion selling non-core businesses.

Now with cash in hand, the company decided to first meet the liquidity requirements and then cut down debt to ensure financial stability. After making the balance sheet appropriate, the company went ahead with share buybacks.

Rationality

Buffett’s purchase of General Dynamics was a different one. Neither was the business simple to understand, was government control, did not have favorable long-term prospects nor was generating high ROE. Then why did Buffett purchase it? Well, as the author finds out that Buffett initially thought of purchasing the company as an arbitrage opportunity as the company had announced a buyback. However, as he studied more about the company and got to know Anders (the CEO), he was mesmerized by his rational and well-articulated strategy of disinvestment.

Additionally, the company was available at below the book value, hence was a value buy. From 1992 to 1993, for its investment of $72, Buffett received $2.60 in dividends, $50 in special dividends and the share price had risen to $103.

Buffett's Investments: Wells Fargo & Company

Buffett bought Wells Fargo (Bank) in a tussle with a bear cartel who were hammering the stock in the midst of recession in 1990. Buffett was familiar with the banking business as he had earlier acquired Illinois National Bank. He understood that to sustain a bank just two things were important – sensible credit writing (whom to give loans and whom to not give) and low-cost operations.

Favorable long-term prospectus

Although banking is not the best in class business (high ROE earning), however, with efficient cost management, it can generate a 20% ROE according to Buffett, which is above average. Hence look for banks run by capable management who are focused on low-cost operations.

Rationality

Carl Reichardt (Chairman) was responsible for turning around the bank. Although he did not announce any special dividends or share buybacks, he still ran the business for the benefit of its owners. He got the bank to the position of 10th largest bank in the U.S. by 1990.

Determine the value

The bank’s income statement was affected by the one-time loan loss provisions because of which its profitability got affected. Adjusting for the same, the company has a $1bn of earnings power.

The value of a bank is its Net Worth + Projected Earnings as a going concern.

• Earnings in 1990 = $600mn
• Yield of 30-year U.S. government bond = 9%
• Value of the bank = 600 mn/9% = $6.6bn
• Shares outstanding = 52 mn
• Per Share price = 6.6 bn / 52 mn = $126
• Purchase price for Buffet = $58

Therefore, Buffett purchased Wells Fargo at a 55% discount to its intrinsic value of $126 per share.

Buffett's Investment: American Express Company

You may remember that during the days of Buffett Limited Partnership (mid-1960s), Buffett had invested 40% of the partnership’s assets in American Express when the share price fell due to the Salad oil scandal. He rebought it 30 years later in the Berkshire Hathaway's portfolio. 

Consistent operating history

Although a bank, the banking operations contribute just 5% to the total sales of American Express. The rest is contributed by travelers’ cheque (72%) and financial planning, insurance and investment product division (22%). The travel business has always been there and has contributed significantly to the company’s growth and profitability.

Rationality

As a part of corporate restructuring, Harvey Golub (the incumbent CEO) started divesting businesses in order to unlock value for the first 3-4 years of his becoming the CEO. The financial targets of the company were set to grow 12-15% annually and to achieve 18-20% ROE; additionally, post the corporate restructuring, Golub announced a series of buybacks. 
By 1995, Berkshire owned 10% of the company.

Determining value

Since Golub had presented a plan to grow the company’s earnings by 12-15%, considering these assumptions in the discounted cash flow model and using 10% earnings growth for the next 10 years and 5% thereafter, and discounting the cash flows @8% (U.S. 30-year treasury), the intrinsic value of the company will be $100 per share. Buffett purchased it at a 70% discount.

Buffett's Investments: International Business Machines (IBM)

As it was widely believed, Buffett was not a huge fan of technology stocks and even was not involved in any tech stocks during the tech boom of 1990 – 2000s. However, he bought a massive 5.4% stake in IBM for $10.8 billion. Let’s find out why.

Rationality

IBM once was near bankruptcy in 1992. Lou Gerstner was then appointed as the CEO and he started with the corporate restructuring. He sold off the low-margin hardware technology assets and moved the business towards software and services. During his tenure, he also did share buybacks thereby reducing the outstanding shares by almost half in a span to 10 years.  He also raised the dividends by 136%. Then Sam Palmisano became the CEO in 2002 and he continued the business by keeping the focus on services and soft-off the personal computer business. 

Favorable long-term prospects

IT outsourcing made up 32% of IBMs revenues in the 2010s. It was the largest player globally and possessed moat due to high switching cost for its clients.

High profit margins, high ROE 

When Gersten became the CEO in 1994, the ROE of the company was 14% while by the time he retired in 2002, it reached 35%. It grew to a massive 62% during Palmisano’s tenure by 2012. The dramatic reduction in the number of shares outstanding through buybacks, led to the rise in ROE. 

Buffett's Investments: H.J. Heinz Company

Heinz is a stereotypical Buffett style company and can be compared with Coca-Cola. It is even older than Coca-Cola (started some 18 years before Coca-Cola). The company is heavily focused on growing its business in the emerging markets.

Consistent operating history

As stated earlier, Heinz is a company that came into existence even before Coca-Cola in 1869. Therefore, the company has a centuries old operating history.

Favorable long-term prospectus

Since Heinz is focused on emerging markets, it accounts for 80% of the growth in the company's revenues. Therefore, the company has good long-term prospects.

Rationality

Buffett purchased Hienz in partnership with 3G Capital. Heinz was burdened with debt and had a debt to equity ratio of 6:1. Therefore, what Buffett did was he invested $4 billion in equity for 50% stake and $8 billion in redeemable preference shares yielding 9%. The preference shares were a master stroke.

1. These could be redeemed at a significant premium to the cost price in the future
2. It also had attached warrants (similar to options) which will allow Buffett to purchase 5% of the company at a nominal price.

With this deal, Buffett will earn a 6% blended rate of return on his total investment. Even if Heinz loses money, Berkshire (i.e. Buffet) will not lose money.

So, what is the common theme in stock investing by Buffett? 

1. Buffett is in no hurry to sell his stake in the company.
2. Short term price appreciation doesn’t interest him.
3. Buffett is ready to hold a business as long as the return on capital is satisfactory, management is competent and honest and the market does not overvalue the business.
4. Buffett's favorite holding period is “forever”.

Portfolio Management

Portfolio management is the process of buying, selling or holding a security in the portfolio. The three important lessons to learn in portfolio management constructs from Buffett are:

1. His way of building a portfolio for long-term growth
2. His measuring stick for judging the growth in the portfolio
3. His techniques to tackle the emotional rollercoaster due to the fluctuations in the stock prices.

Focus Investing

Buffett calls himself a focus investor, i.e., who focuses on just a few outstanding companies. This chapter deals with the concepts of focus investing. 
Conventionally, there are two types of portfolio management strategies namely – 

1. Active portfolio management
2. Index investing.

Active portfolio managers are consistently in search of outperforming the benchmark (Sensex, Nifty, etc.) and take risky bets in order to generate alpha.

Index investing replicates the return of an index like Sensex or Nifty. Counterintuitively, it is index investing that works better than active investing and figures indicate that more than 50% of large cap funds (active) underperform index funds. Index investing gives the benefit of diversification to investors, i.e., save them from risks of individual stocks.

Buffett is a supporter of index investing; however, he does not support diversification much, at least seen from his portfolio management style. He has numerous times bet in large quantities in individual stocks where he believed, the potential to beat the market was pre-set. This is in accordance with the investing style of Philip Fisher who also did not support the idea of investing in a large number of companies just to avoid risk. 

According to the author, when an investor studies a company as per Buffett’s tenets he gets a company which has a long operating history, is profitable and is run by efficient and honest management. Hence the risk is automatically covered and no need to follow the textual diversification methods. This is called Focus Investing.

Putting Probability Theory to Investing

1. Calculate probabilities: In the stock market investors should take out the probabilities of various outcomes like sales growth, merger, bankruptcy, etc. before taking a financial bet.
2. Wait for the best odds: In the world of probability, odds mean chances that are in your favor. In the world of investing, one should look out for chances or odds when they turn in your favor. Whether you’re buying a stock or selling, patience is the key. Buy when the stock falls below its intrinsic value, sell when it exceeds the intrinsic value.
3. Adjust new information: Also, be vigilant about what is happening with your investment. Never sleep over it. There will always be new information about the company that is going to affect its story and valuation.
4. Decide how much to invest: Position sizing is as important as selecting the right stock. Author has advised using the Kelly formula which is 2p-1 = x, where, p is the probability of winning and x is the percentage of total portfolio that you should bet on a stock. For example, the probability of winning is 55%, then 2p-1 = 2 * 55% -1 = 1.1-1 = 0.1 or 10%. Therefore, bet 10% of your portfolio on the stock.

The author now discusses traits of some of the well known Focus Investors.

John Maynard Keynes

Keynes was a well known economist, however, he was also a legendary investor. He managed the investments for King’s College.  Keynes theory published:

1. An investor can outperform markets if he concentrates on selecting a few companies which are cheaper than other stocks and its potential intrinsic value.
2. These investments should be held for very long periods of time.
3. A balanced investment position. Here he did not specifically mean holding a large number of stocks for diversification but holding large investments in a few securities in different sectors or regions can also cover the risk.

Charlie Munger Partnership

The success of Berkshire Hathaway can be attributed to both Warren Buffett and Charlie Munger. Charlie, a lawyer by profession, was also interested in investing and had an investment partnership to his name before joining hands with Warren Buffett. Since his earlier days, Charlie has been focused on investing in great quality companies that are available at a significant discount to their intrinsic value.

Bill Ruane

Bill was a batchmate of Buffett at Columbia University and was a student of Graham as well. He is the founder of Sequoia Capital. Buffett was a keen follower of Bill’s track record of managing investments. He was so impressed by him that when he closed down the Buffett Partnership, he advised the partners to return to Bill for their investment. He was a risk taker and has grown Sequoia’s assets from 1971 to 2013 at an average annual return of 14.46% as compared to 10.65% for S&P 500.

Lau Simson

Lau headed the GIECO (insurance division) of Berkshire Hathaway. He was regarded by Buffett as a Focused Investor. Surprisingly, GEICO's billion-dollar investment portfolio had just 10 stocks. Simson, like Buffett, invested in companies that were generating high returns on capital and were run by able managers. He believed that the right temperament to invest in is not to be happy or sad being against or with the crowd. He pondered over annual reports rather than research reports to select his stocks.

It's common between all these five investors (Buffett and the four mentioned above) to buy stocks with a significant margin of safety and concentrating the portfolio among a few high-quality names helps to generate the best returns.

Let’s summarize the focused investing approach:

1. Think of investing in stocks as buying part ownership in a business.
2. Study the business that you own along with the peers of the company.
3. The minimum investment period should be 5 years.
4. Never buy investment stocks on leverage. 
5. Attain the right temperament and personality to invest.

The Psychology of Investing

In the beginning of the chapter, the author recalls the concept of “Mr. Market” given by Ben Graham in his book The Intelligent Investor. Consider the stock market as a person named, Mr. Market. He is a very emotional person. He will get excited on good news and will give you higher quotes on such dates. Similarly, he gets sad very easily and will give you lower quotes of the same script in case a bad day arrives. There is one more important characteristic of Mr. Market, he does not mind getting snubbed. If Mr. Market’s quotes are ignored, he will still come back the next day in another mood. Now, it is up to you, whether you get influenced by Mr. Market, or take advantage of him.

Now the chapter shifts toward some of the behavioral finance concepts.

Overconfidence

Investors are generally overconfident that they are smarter than others. This is the major reason for the underperformance of active fund managers. This should be avoided.

Overreaction Bias

With the advancement of information technology people are overloaded with information and have the ability to check stock prices every minute. This leads to overreaction over a certain news or event which otherwise was not that important. The only fixation to this bias is to invest and don’t check your phone continuously. 

Loss Aversion

Warren Buffett advises us to be greedy when others are fearful and fearful when others are greedy. But is it that easy to do? Imagine the fall seen during the corona virus outbreak. There was blood on the wall street and hence difficult to resist fear. However, if we could understand how greed and fear affect our financial decisions, we might be able to react in a better way. 

The fear of making a loss is called Loss Aversion. 

Let's dig deeper into the concept of loss aversion. Say you are given ₹1000  and two options

1. Fixed gain of 500
2. Flip a coin, If heads – get 1000, if tails – get nothing

In a survey, most of the people chose option A. Let’s take another example,

1. Fixed loss of 500
2. Flip a coin, heads you lose 1000, tails nothing

Here, in the survey, the majority chose option B.

If you have studied probability, in both the examples, the expected cash flow was the same, 500 so you should have been indifferent ideally.

But choosing option B in the second example and option A in the first suggests loss aversion. Since a fixed loss of 500 is unbearable, we would take the risky option B, wherein the chance of losing nothing was also there. Whereas in the first example, the sure gain is preferred over bumper gain involving luck/chance. 

Loss aversion is there in our mind subconsciously and has the following effects on us.

• Preference for fixed income over equities
• Booking profits early on fear of losing the gain
• Taking more risk than warranted due to instability of mind. Remember in the stock market people are loss averse (loss fearing) not risk averse.
• Hold on to losers and sell the winners
• Tax aversion is the resistance to pay taxes. Subconsciously we want to pay less tax which leads us to generate lower income. The trick is to always count your income net of tax.

Mental Accounting

Mental accounting is when we consider money used for different purposes as different instead of both being earned in the same checking account. For example, suppose you had to pay the barber $10 but didn’t find the $10 note in your pocket. Therefore, you went to the ATM, encashed another $10 and gave it to the barber. However, later you found the same $10 note in your pocket and henceforth felt it as free money. This is a wrong notion, since both the $10 belonged to you and hence should not be considered as different.

The same happens in the world of finance, wherein you invest in bonds for your daughter's marriage and stocks for retirement income. Whereas, the correct methodology should be to estimate the future cash requirements, the risk that you can take and then design a portfolio that suits the cash flows and risk profile the best.

The Lemming Factor

This is the behavioral trait that explains the investor’s choice to follow what the majority of others are doing. Buffett wants us to consider professional money managers, who are all too frequently paid by a system that equates safe with average and favors obedience to traditional methods over independent thought, in order to help investors avoid this trap.

Managing Emotional Traps

Recovering from a loss is the most difficult task for investors and hence is an important concern for people to be able to follow the Warren Buffett Way. Warren Buffett has been able to tackle the myopic loss aversion bias and hence is very successful. He was able to do this because of the structure of Berkshire Hathaway. Berkshire owns both common stocks and wholly owned businesses. This makes him understand the value of businesses rather than concentrating just on the stock prices. 

Investors must be prepared for stock market volatility. Hence, they should only buy stocks that they may own for at least 5-10 years. Buffett says that once he buys any stock, he would be happy if the stock market closes for the next 10-years, so that he doesn’t need to think about selling.

 
Investors must be prepared for the stock market volatility. Hence, they should only buy stocks that they may own for at least 5-10 years. Buffett says that once he buys any stock, he would be happy if the stock market closes for the next 10-years, so that he doesn’t need to think about selling.

Academicians over the years have come up with a few important concepts that reduce the risks in the portfolio. The most important ones are: -

Harry Markowitz – Covariance

Markowitz proved through mathematical calculations that no investor could earn above average return (returns more than the index) without assuming above average risk. He devised that diversification of the portfolio should be done by looking at the covariance of the stocks with respect to the index. The more related a stock is to the index, the higher the risk that both will move down simultaneously.  Hence a risky stock may be a conservative investment if its covariance with the market is negative or if it moves in the opposite direction to the market. Hence you will outperform when the market underperforms. 

Eugene Fama – The Efficient Market

Market is efficient and information is available to everyone. Hence it is almost impossible to outperform the market.

Bill Sharpe – Capital Asset Pricing Model

There are two types of risks, systematic and unsystematic risk. 

Systematic risk is the risk of the market and can not be diversified away. Unsystematic risk is the risk of an individual stock and can be diversified by holding a large number of stocks in the portfolio. For example, the GDP growth decelerating is a systematic risk and hence all the stock operating in India will go down if the GDP falls. On the other hand, Satyam filing for bankruptcy post the fraud disclosure was an unsystematic risk and hence can be diversified by simply holding a large number of stocks in the portfolio or keeping a cap of individual holdings as a % of the total portfolio, say any stock cannot be more than 5% of the total portfolio.

As we have already read, Buffett and Munger disagreed with all these theories of diversification. Their understanding was that if you know the business well and you buy it at a reasonable price, the risk is diversified away. 

Conclusion

Buffett has been unbeatable in his investing career spanning 70 years+, right from the Buffett Partnership days. 1965 - 2012, he was able to generate a return of 19.7% compounded vs 9.4% for S&P 500.

Since childhood, Buffett was so confident in his money-making skills, that he pronounced he would become a millionaire by age 30. If not, he would jump off the tallest building in Omaha. Today, he has far exceeded his dream, however, it doesn’t mean that his lifestyle has changed. He still lives in an old house that he bought in 1958, drives an old-modeled car and prefers to eat cheese burgers, cokes and ice creams.

Buffett opposes efficient market theory and believes in doing an in-depth analysis of companies and investing a good amount for the long term. A successful business has three advantages:

Behavioral advantage

The driving force behind Warren Buffett’s success is not IQ; rather, it’s rationality. Determining how to allocate capital in a business is the most important decision.

Analytical advantage

A business owner and investor should look at the business in the same way, as essentially, they want the same thing out of business, the creation of value. Buffett advises students that if you think that market is smarter than you, then do index investing. On the other hand, if you are capable of studying businesses, turn off the market after purchasing individual stocks. Buffett is a casual observer of the economy but does not spend time predicting the economy at all.

Organizational advantage

The organizational structure of the company is of utmost importance for its success. The success of Berkshire stands on three pillars:

1. The company’s subsidiary generates a lot of cash
2. Buffett is a capital allocator
3. Decentralization. All subsidiaries are managed by a separate management team and Buffett has little intervention in day-to-day activities.