Mr Buffett, What are More of Your Secrets?
posted on April 11th, 2011 by Bellmont Research Team
Mr Buffett, What are More of Your Secrets?
In my last article “Mr Buffett, What are Your Secrets?” I wrote about Warren Buffett’s “secrets”. My point was that when you know where to look, you will find answers to most of the main questions that investors want to know from Buffett. He has already answered them in his writings and interviews over the years. The article was written as a make-believe interview taking place in Gorat’s Steak House in Omaha, Nebraska, Buffett’s favourite place to eat.
The interview ended with me arranging to meet Buffett the next day at which time he was going to tell me how to estimate the return you will get when you make a purchase. He also offered to talk about how to analyse the risks associated with businesses and the importance of margins of safety.
When we meet, as usual Buffett orders a rare T-bone, a double order of hash browns, three cherry cokes, and follows with a chocolate ice-cream sundae.
JP: Most people are wary of the stock market because it is risky. They prefer to hand their money over to professional financial advisors or invest in managed funds. What are your thoughts on risks in the stock market?
WB: Over the years I have made lots of comments on this topic. The first point is, as I said in an interview back in 1994 “Risk comes from not knowing what you are doing.” For example, here is what I told Washington Post reporter Bob Woodward (of Watergate fame) a few years ago, “Investing is reporting. I told him to imagine he had been assigned an in-depth article about his own paper. He’d ask a lot of questions and dig up a lot of facts. He’d know the Washington Post. And that’s all there is to it.”
JP: Where do you get most of your information?
WB: As I explained in the annual meeting of Berkshire Hathaway in 1993, “I read annual reports of the company I’m looking at, and I read the annual reports of the competitors—that is the main source of material.”
It is also important to stay within your circle of competence. “Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times.”
JP: In Teaminvest we have a process for examining the future risks of companies that we are interested in. We call it a Risk and Pricing or RAP workshop. We analyse companies as a group of active investors. When looking at the report by the chairman and CEO, the sorts of questions we ask are: “Is it informative and clear? Has the company delivered on the intentions stated in earlier reports? Does management describe and accept mistakes?”
WB: Exactly. As I have explained many times. Put yourself in the frame of mind that you had just inherited a company and it was the only asset that your family was ever going to own. Typical questions are:
“What would I do with it? What am I thinking about? What am I worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus the other ones.”
JP: We also look at the remuneration report. The questions we look at are: “Are we comfortable with their total remuneration in light of the results they have achieved for us? Are we comfortable with the mix of fixed salary, short-term bonuses and long-term incentives? Are we comfortable that the rules for achieving incentives are clear? Are we comfortable that these bonuses should motivate management to achieve what we would like them to achieve for us as part-owners of the business?”
I recall in this regard you mentioned a mythical company called Ratchet, Ratchet and Bingo. What did you mean by that?
WB: Here is what I wrote in the 2005 annual report: “Too often, executive compensation in the U.S. (JP: and in Australia) is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay.
The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.”
JP: What about compensation committees?
WB: In the 2002 annual report of Berkshire Hathaway I wrote: “In recent years compensation committees too often have been tail-wagging puppy dogs meekly following recommendations by consultants, a breed not known for allegiance to the faceless shareholders who pay their fees. (If you can’t tell whose side someone is on, they are not on yours.) True, each committee is required by the SEC to state its reasoning about pay in the proxy. But the words are usually boilerplate written by the company’s lawyers or its human-relations department.
This costly charade should cease. Directors should not serve on compensation committees unless they are themselves capable of negotiating on behalf of owners. They should explain both how they think about pay and how they measure performance. Dealing with shareholders’ money, moreover, they should behave as they would were it their own.”
JP: I get it. What about margins of safety. What does that mean?
WB: One of the most important aspects of the margin of safety is the amount of debt that a company carries. In the 1990 annual report of Berkshire Hathaway I wrote:
“Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We’ll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly – and unnecessary – accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.
In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: ‘Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.’ Forty-two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses as the 1990s began.”
“In general, we continue to have an aversion to debt, particularly the short-term kind. But we are willing to incur modest amounts of debt when it is both properly structured and of significant benefit to shareholders.”
JP: In my book The Conscious Investor I talk about margins of safety in the sense of stress testing investments before actually making a purchase. I describe computer-based automatic margins of safety in the areas of business performance, market opinion and board policy.
WB: This sounds similar to something else that Benjamin Graham said. It was along the lines that when margins of safety are introduced into investing, it is “somewhat as an engineer does in his specifications for a structure”.
JP: In the 2003 annual report of Berkshire Hathaway you said that you want to be confident about the return you are going to get with an investment. How do you do that?
WB: It is simple. Look for companies for which you can have confidence that their earnings will continue to grow. Here is what I wrote in the 1996 annual report: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.
Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value. Though it’s seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders.”
Added later by JP: Having said that, Buffett rattled off a list of companies showing how their performance matched the growth of their earnings. We shook hands and he left. I quickly got out my computer and looked up data on a few companies comparing the growth of price with the growth of earnings per share. Over and over I saw what he said was true. For companies with a stable growth in earnings the price and earnings tracked each other. Sometime the price lagged behind the earnings (a buying opportunity) and sometimes it ran ahead. For example, consider ARB Corporation. The chart shows how over time the growth of the price matches the growth of earnings per share. Over the ten years earnings grew by around 17 percent and price by around 19 percent. When you combine this with the dividends, an investment of $10,000 ten years ago in ARB would now be worth around $90,000 pre-tax assuming that all dividends were invested.
John Price – Team Invest