The Warren Buffett Reading Club

Warren Buffett is often called the "Sage of Omaha" or the "Oracle of Omaha". Warren Buffett has amassed an enormous fortune from astute investments managed through the holding company Berkshire Hathaway, of which he is the largest shareholder and CEO.

With an estimated current net worth of around US$55.4 billion, he was ranked by Forbes as the second-richest person in the world as of September 2007, just behind his buddy, Bill Gates. At the beginning of 2008, however, Buffett took the top spot after his fortune increased to $62 billion, more than $2 billion ahead of Bill Gates's $60 billion.

Warren Buffett is renowned for his unconventional style and frugality despite his immense wealth. His 2006 annual salary of about $100,000 is tiny by the standards of senior executive remuneration in other comparable companies, and when he spent $9.7 million of Berkshire's funds on a corporate jet in 1989, he jokingly named it "The Indefensible" because of his past criticisms of such purchases by other CEOs. He continues to live in the same house in the central Dundee neighbourhood of Omaha, Nebraska that he bought in 1958 for $31,500, today valued at around $700,000.

In addition to Warren Buffett's iconic stature in the business world, he is a well regarded philanthropist.

In 2006, Buffett announced a new plan to give away much of his fortune to charity, with 83% of it going to the Bill and Melinda Gates Foundation.

The donation will amount to approximately US$30 billion, at the time of the announcement enough to more than double the size of the foundation. However, this figure will increase as the value of his shares in Berkshire Hathaway increase. In 2007, Warren Buffett was listed among Time's 100 Most Influential People in The World.

His Life
Warren Buffett was born in Omaha, Nebraska to Howard Buffett, a stock broker and United States Representative, and his wife Leila Buffett. Warren Buffett displayed an extremely keen understanding of business and mathematics at a young age, easily doing complex mathematical computations in his head. He was also known as a bookworm who displayed an insatiable hunger for knowledge pertaining to business and capital markets.

He began working at his father's brokerage at the age of 11, and that same year made his first stock purchase, buying Cities Services shares for $38.25 each.

He sold them when the price reached $40, only to see them rocket to $200 a few years later. This taught him the importance of investing in good companies for the long term. At the age of 14, he and a fellow high school student began installing pinball machines in barber shops, and he eventually spent his take of $1,200 to start a band. He and two friends played in the band for 2 years until they disbanded.

Following his graduation from Washington, DC's Woodrow Wilson High School in 1947, Warren attended the prestigious Wharton School at the University of Pennsylvania for two years, then transferred to the University of Nebraska. There he began his interest in investing after reading Benjamin Graham's The Intelligent Investor.

He obtained a Master's degree in economics in 1951 at Columbia University, studying under Benjamin Graham, alongside other future value investors including Walter Schloss and Irving Kahn. Another influence on Warren Buffett's investment philosophy was the well known investor and writer Philip Fisher. After receiving the only A+ Benjamin Graham ever handed out to a student in his security analysis class, Warren Buffett wanted to work at Graham-Newman but was initially turned down. Instead, he went to work at his father's brokerage as a salesman until Graham offered him a position in 1954. Warren Buffett returned to Omaha two years later, when Graham retired.

His Partnerships
Warren Buffett established Buffett Associates, Ltd., his first investment partnership, in 1956. It was financed by $100 from Warren Buffett, the general partner, and $105,000 from seven limited partners consisting of Warren Buffett's family and friends.

Warren Buffett created several additional partnerships which were later consolidated as Warren Buffett Partnership Limited. He ran the partnerships out of his bedroom, adhering closely to Graham's investment approach and compensation structure. These investments made in excess of 30% compounded annually between 1956 to 1969, in a market where 7% to 11% was the norm.

Warren Buffett employed a three-pronged approach:

Generals: undervalued securities that possess margin of safety and meet expected return-to-risk characteristics.
Arbitrages: company events that are not related to broader market changes, such as mergers and acquisitions, liquidation, etc.
Controls: build sizable holdings, ally with other shareholders or employ proxies to effect changes in companies.

Berkshire Hathaway
In 1962 Warren Buffett Partnerships began purchasing shares of Berkshire Hathaway, a large manufacturing company in the declining textile industry that was selling for less than its working capital. In 1969, Warren Buffett would dissolve all his partnerships to focus on running Berkshire Hathaway. At the time, Charlie Munger, Berkshire's current Vice Chairman, remarked that purchasing the company was a mistake, due to the failure of the textile industry. Berkshire, however, became one of the largest holding companies in the world, as Warren Buffett redirected the company's excess cash to acquire private businesses and stocks of public companies. At the core of his strategy were insurance companies, due to the large cash reserves they must keep on hand to pay out future claims. Essentially, the insurer does not own the reserve, but may invest it and keep any proceeds.

Under Charlie Munger's influence, Warren Buffett's investment approach moved away from a strict adherence to Graham's principles, and he began to focus on high-quality businesses with enduring competitive advantages. Warren Buffett described such advantages as an economic "moat" that kept rivals at a safe distance, as opposed to commodity businesses, which sell undifferentiated products and face direct competition. A classic example of a wide-moat company is Coca-Cola, because consumers are willing to pay more for a Coke than for a generic beverage with a similar taste. On the other hand, salt is considered a commodity product because consumers generally have no preferences for one brand of salt over another.

Investment in wide-moat businesses has become a hallmark of Berkshire Hathaway, particularly when buying whole companies rather than public stocks. As a result, it now owns a large number of businesses which are dominant players in their respective industries, specialize in various niche markets, or possess other unique characteristics to separate them from their competitors.

Management style
Warren Buffett views himself as a capital allocator above anything else. His primary responsibility is to allocate capital to businesses with good economics and keep their existing management to lead the company.

When Warren Buffett acquires a controlling interest in a business, he makes clear to the owner the following:

He will not interfere with the running of the company.

He will be responsible for hiring and setting the compensation of the top executive.
Capital allocated to the business will have a price tag (a hurdle rate) attached, usually a requirement of a return on capital in excess of fifteen percent. This process is to motivate owners to send excess capital that does not return more than its cost to Berkshire headquarters rather than investing it at low returns. This cash is then free to be invested in opportunities that offer higher returns.
Warren Buffett's hands-off approach has held strong appeal and created room for his managers to perform as owners and ultimate decision makers of their businesses. This acquisition strategy enabled Warren Buffett to buy companies at fair prices because the sellers wanted room to operate independently after selling.

Besides his skills in managing Berkshire's cash flow, Warren Buffett is skilled in managing the company's balance sheet. Since taking over Berkshire Hathaway, Warren Buffett has weighed every decision against its impact on the balance sheet. As of 2005, he has succeeded in building Berkshire into one of the nine companies that are still rated by S&P as AAA, the highest credit rating achievable and thus, with the lowest cost of debt. Warren Buffett takes comfort in his belief that, for the near future, his company will not be one of those shaken by economic or natural catastrophes. He has repeated over the years that his catastrophe insurance operation is the only one he knows of that can keep the checks clearing during a financial turmoil.

Investment Philosophy
Warren Buffett's philosophy on business investing is a modification of the value investing approach of his mentor Benjamin Graham. Graham bought companies because they were cheap compared to their intrinsic value. He was of the belief that as long as the market undervalued them relative to their intrinsic value he was making a solid investment. He reasoned that the market will eventually realize it has undervalued the company and will correct its course regardless of what type of business the company was in. In addition he believed that the business has to have solid economics behind it. Warren Buffett's investment style is also heavily influenced by Phil Fisher.

The following are some questions to determine what business to buy, based on the book Buffettology by Mary Buffett:

Is the company in an industry with good economics, i.e., not an industry competing on price. Does the company have a consumer monopoly or brand name that commands loyalty? Can any company with an abundance of resources compete successfully with the company?
Are the Owner Earnings on an upward trend with good and consistent margins?
Is the debt-to-equity ratio low or is the earnings-to-debt ratio high, i.e. can the company repay debt even in years when earnings are lower than average?
Does the company have high and consistent Returns on Invested Capital?
Does the company retain earnings for growth?
The business should not have high maintenance cost of operations, high capital expenditure or investment cash outflow. This is not the same as investing to expand capacity.
Does the company reinvest earnings in good business opportunities? Does management have a good track record of profiting from these investments?
Is the company free to adjust prices for inflation?
Warren Buffett also concentrates when to buy. He does not want to invest in businesses with indiscernible value. He will wait for market corrections or downturns to buy solid businesses at reasonable prices, since stock market downturns present buying opportunities.

Warren Buffett is known for being conservative when speculation is rampant in the market and being aggressive when others are fearing for their capital. This contrarian strategy is what led Warren Buffett's company through the Internet boom and bust without significant damage, although critics have also noted that it may have led Berkshire to miss out on potential opportunities during the same period.

He also asks at what price is the business a bargain, and his answer typically is when it provides a higher rate of compounded return relative to other available investment opportunities.

Warren Buffett's letters to shareholders are a valuable source in understanding his investment style and outlook.

Philanthropy
In June 2006, Warren Buffett gave approximately 10 million Berkshire Hathaway Class B shares to the Bill & Melinda Gates Foundation (worth approximately USD 30.7 billion as of June 23 2006; see [4]) making it the largest charitable donation in history. The foundation will receive 5% of the total donation on an annualized basis each July, beginning in 2006. Warren Buffett will also join the board of directors of the Gates Foundation, although he does not plan to be actively involved in running the foundation.

Warren Buffett also announced plans to contribute additional Berkshire stock valued at approximately $6.7 billion to the Susan Thompson Buffett Foundation and to other foundations headed by his three children. This is a significant shift from previous statements Warren Buffett has made, having stated that most of his fortune would pass to his Buffett Foundation. The bulk of the estate of his wife, valued at $2.6 billion, went to that foundation when she died in 2004.

His children will not inherit a significant proportion of his wealth. These actions are consistent with statements he has made in the past indicating his opposition to the transfer of great fortunes from one generation to the next. Warren Buffett once commented, "I want to give my kids just enough so that they would feel that they could do anything, but not so much that they would feel like doing nothing".

Writings
Warren Buffett's writings include his annual reports and various articles. In his article The Superinvestors of Graham-and-Doddsville, Warren Buffett condemned the academic position that the market was efficient and that beating the S&P500 was "pure chance" by highlighting a number of students of the Graham and Dodd value investing school of thought. In addition to himself, Warren Buffett named: Walter J. Schloss, Tom Knapp, Ed Anderson (Tweedy, Brown Inc.), Bill Ruane (Sequoia Fund, Inc.), Charles Munger, Rick Guerin (Pacific Partners, Ltd.), and Stan Perlmeter (Perlmeter Investments) as having beaten the S&P500, "year in and year out".

Warren Buffett believes that the U.S. dollar will lose value in the long run. He views the United States' expanding trade deficit as an alarming trend that will devalue the U.S. dollar and U.S. assets. As a result it is putting a larger portion of ownership of U.S. assets in the hands of foreigners. This induced Warren Buffett to enter the foreign currency market for the first time in 2002. However, he substantially reduced his stake in 2005 as changing interest rates increased the costs of holding currency contracts. Warren Buffett continues to be bearish on the dollar, and says he is looking to make acquisitions of companies which derive a substantial portion of their revenues from outside the United States.

Warren Buffett's speeches are known for mixing serious business discussions with humour. Each year, Warren Buffett presides over Berkshire Hathaway's annual shareholders' meeting in the Qwest Center in Omaha, Nebraska, an event drawing over 20,000 visitors from both United States and abroad, giving it the nickname "Woodstock of Capitalism".

Berkshire's annual reports and letters to shareholders, prepared by Warren Buffett, frequently receive coverage by the financial media. Warren Buffett's writings are known for containing literary quotes ranging from the Bible to Mae West, as well as Midwestern advice and numerous jokes. Various websites extol Warren Buffett's virtues while others decry Warren Buffett’s business models or dismiss his investment advice and decisions.

Although Warren Buffett has never written a book detailing his investment style, much can be gleaned from the annual letter he sends to Berkshire shareholders.

Warren Buffett does not view the purchase of shares in a company as buying a stake in that business, but believes that the investor should feel that they are actually buying that business outright. Because of that Warren Buffett looks for quality management, a durable competitive edge and low capital expenditure.

Companies tend to have a strong brand name – Coca Cola, McDonalds and Gillette feature in his holdings – and a good history of solid earnings growth.

'Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.'

Value Investing

'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'

The basic premise of Warren Buffett's investing style is buying something for less than it's actually worth. This sounds simple enough, but unearthing these stocks and prove difficult and it's easy to mistake a company that is unloved by the market because nobody has spotted its opportunity with one that is simply a dog. For that reason, Warren Buffett applies some of the measures that are listed below.

Strong Profitability

'If a business does well, the stock eventually follows.'

Warren Buffett prefers to invest in companies with a proven level of strong profitability, giving more credence to this than what analysts predict will happen in the future. Warren Buffett looks at a number of measures to assess a business's profitability, including return on equity (ROE), return on invested capital (ROIC) and a company's profit margin.

ROE is a measure of the rate at which shareholders are earning income on their shares and Warren Buffett uses this measure to see how well a company is performing compared to other businesses operating in the same sector. You can calculate the ROE by dividing the company's net income by the shareholder's equity. It is believed that Warren Buffett prefers a company that has an ROE in excess of 15%. Warren Buffett also looks for companies with above average profit margins, which can be calculated by dividing net income by net sales. The higher the ratio, the more profitable the company based on its level of sales.

Not too much in debt

'Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.'

However, a company with a high ROE could be being fuelled by substantial levels of debt, which Warren Buffett is keen to avoid. For this reason Warren Buffett also takes into accounted the ROIC. This helps take debt out of the equation by adding it back to the shareholder equity before doing the calculation. This can be calculated by dividing a company's total liabilities by its shareholder equity – the higher the ratio, the higher the level of debt the company is using to fuel its growth.

Warren Buffett doesn't like over-indebted companies, as he says each year in his Berkshire Hathaway letters, because they could become vulnerable in a credit squeeze or when interest rates are rising, as they have been doing recently.

Understanding the Business

'Risk comes from not knowing what you're doing.'

Warren Buffett will only invest in businesses he can understand and analyse, rejecting those that operate in complicated markets or where he is unsure of their operating model. Warren Buffett describes this as his 'circle of competence'. He has largely ignored the technology sector because he claims not to fully understand their business, but prefers retailing, food and insurance stocks.

Strong Management

'It's better to hang out with people better than you, ... Pick out associates whose behaviour is better than yours and you'll drift in that direction.'

Warren Buffett places great emphasis on the quality of a company's management. According to Robert Hagstrom, author of 'The Warren Buffett Way', he asks three questions of a company's management team:

Are they rational?

Do they admit to mistakes?

and, do they resist the institutional imperative?

Warren Buffett takes a dim view of management teams that simply follow the crowd, copying the lead of competitors. Warren Buffett also likes companies to have been floated for a 10-year period before investing, but says he never interferes with the running of a company.

The 'Moat'

'Your premium brand had better be delivering something special, or it's not going to get the business.'

Warren Buffett coined the phrase 'moat' to refer to the competitive advantage or unique proposition that gives a business protection against their competitors. Warren Buffett says those businesses that have a wider moat will offer more protection to the main core business, which he refers to as the castle. This could be geographical, entry costs, a strong brand name or owning a particular patent. Warren Buffett tends to pick companies that offer strong brand names, even though there is a lot of competition in their particular markets. Examples include McDonalds, Coca-Cola and Gillette.

Moats are important to investors because if a business develops a successful product it is likely to be aped by competitors. How effectively it can survive is largely determined by how its product differs from the others in the market and why consumers will keep coming back.

Long-term hold

'Our favourite holding period is forever.'

When Warren Buffett buys a stock he buys it with the view of holding it for life. Warren Buffett holds a number of permanent stocks in his portfolio, including Coca-Cola, GEICO and Washington Post, which he claims he'll not sell even if they appear to be significantly overpriced. This approach has led to accusations that his portfolio has a number of 'tired' stocks in it, but Warren Buffett thinks investors are too quick to buy and sell.

Don't Rush

'You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.'

Boredom can cause rash buying decisions, forcing the investor to buy stock at the wrong time. Warren Buffett has proved to be a master at the waiting game, preferring to sit on his cash rather than buy into a company just for the sake of it. He understands markets rise and fall and would prefer to wait until he feels a stock is cheap enough to buy. Warren Buffett says investors would be better off if they could only invest a limited number of times, so they would make sure they were making the right investment.

The Warren Buffett Reading Club warren-buffett.co.uk