Mr Buffett, What is Your Secret?
posted on November 10th, 2010 by Bellmont Research Team
If you had the chance to interview Warren Buffett, the chairman and CEO of Berkshire Hathaway, what would you ask? When you know where to look, you may be surprised to find that he has already answered most of your questions. If I were to interview him, I would like it to take place in Gorat’s Steak House in Omaha, Nebraska, Buffett’s favourite place to eat. As he does every time, he orders a rare T-bone, a double order of hash browns, three cherry cokes, and follows with a chocolate ice-cream sundae.
The following is a transcript of my imaginary interview.
JP: Mr Buffett, before I ask you about your investing secrets, can you tell me about your track record?
WB: It depends how far you want to go back. To keep it simple, I’ll just describe it since my start with Berkshire Hathaway. Back in the 1960s it was an established textile company. I bought my first shares in the business for $7.50 on Wednesday, December 12, 1962, and on Tuesday, December 11, 2007, almost exactly 45 years later, they reached $151,650, an all-time high.
[At this stage I started scribbling some calculations on a piece of paper. I had barely written down a few numbers when Buffett continued.]
WB: This is an average annual return of over 24 percent.
JP: Remarkable. What happened next?
WB: The price tumbled to a low of $70,050 on Thursday, March 5, 2009. But today it is back around $125,000. This means approximately an average of 22.5 percent per year over more than 47 years.
JP: So this is an example when the share price more than halved. Has this ever happened before?
WB: I recall it happened in 1974, in 1987, and again in 1998. Each time, like a punch-drunk fighter, it picked itself up off the canvas and headed for record highs. The important lesson from this is to take your guidance from the business and not from the price. Behind these extreme swings, practically every year the business of Berkshire kept adding value. Savvy investors are not perturbed by these swings. Quite the opposite: they welcome them.
JP: Why is that?
WB: It does not matter what company you are talking about, when the underlying business is strong and growing, such swings in the price just give the opportunity of buying more shares at bargain prices, something that Charlie and I like very much. [“Charlie” is Charlie Munger, the vice chairman of Berkshire Hathaway and long-term friend of Buffett.]
JP: I get it. Look for quality businesses but only buy when their prices are lower than usual. But what is your secret in picking companies that are strong and growing in the first place?
WB: [Laughing] It is not really a secret since I describe the most important points every year in the annual report of Berkshire Hathaway.
JP: But tell us anyway.
WB: For a start the businesses must have [at this stage Buffett pulled out a copy of the latest annual report of Berkshire Hathaway and read] “demonstrated consistent earning power. Future projections are of no interest to us, nor are ‘turnaround’ situations.”
JP: That’s interesting. There seems to be two points here. The first is that at least the earnings have to be positive and the second is that they should be growing in a consistent way. I did some research on the Australian market and found that only 37 percent of companies made a profit over the last 12 months. Putting it another way, well over 1,100 companies did not make a profit for their shareholders, their real owners.
WB: It is the similar in the US. Even on the New York Stock Exchange, NASDAQ and the American Stock Exchange, where the listing requirements are much higher, only about 60 percent of the companies made a profit over the past 12 months. The percentage is much lower on the smaller exchanges. It is no wonder that the prices of so many shares never meet their touted expectations. A few years back I wrote, “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.” If you have companies with growing earnings, provided you don’t pay too much, you are going to do well.
JP: Can you give me an example?
WB: Sure. Consider Berkshire. Since 1996 earnings per share have grown by a multiple of around 3.7 and the price has grown by about the same amount. This correlation may vary a little for other companies, and it may be different when a company pays out a high proportion of its earnings as dividends. But over time good growth in earnings means good growth in price.
JP: But how can we have this confidence about the growth of earnings of other companies on the stock market or in other countries?
WB: It doesn’t matter where you are. As I said, the past growth of earnings has to be consistent. This consistency in the growth shows that management understands their business. They are able to build it each year despite changes in consumer preferences and the business environment.
JP: To measure this consistency I developed a function called STAEGR® which stands for stability of earnings growth. It measures the stability of earnings growth with more emphasis on recent years. Using extensive studies on US and Australian markets I showed that when companies have a high level of stability over the past four or five years as measured by STAEGR, they tend to continue growing at a similar rate. It gives a more accurate way of making earnings forecasts.
WB: That sounds useful. In my case I just look at companies one at a time. But I can see the advantage in being able to use a computer to scan the whole market looking for companies with earnings and sales growth that is strong and consistent.
JP: What else do you look for?
WB: Two more important criteria are [reading from the report] “Businesses earning good returns on equity while employing little or no debt.”
WB: Return on equity is the earnings of a company divided by its equity. It is a measure of management’s ability to use the equity available to it. Think of it as part of management’s scorecard. If they are only earning a few percent on the equity of the business, that is the most that you can expect. Overall we want companies that have return on equity of at least 15 percent. After all, presumably you want to earn at least this amount on your own equity. So why would you invest in a company that does not earn this amount on its own equity?
JP: When you put it like that it makes sense. What about debt?
WB: Debt is a four-letter word around Berkshire. Last year I wrote that “we use debt sparingly. We will reject interesting opportunities rather than over-leverage our balance sheet. [We would never trade] a good night’s sleep for a shot at a few extra percentage points of return.” This is the debt of Berkshire. But it is the same when we are investing in companies. We just don’t want to be involved in companies with high debt.
JP: But don’t some companies need high levels of debt?
WB: There are two types of debt, discretionary and nondiscretionary, and they are both dangerous if they are too high. Apart from start-ups, nondiscretionary debt is when the company needs extra capital to maintain its economic position and without it could lose ground in maintaining its volume of sales or long-term competitive position. Resource companies are often in this category. They seem to have an almost insatiable desire for more capital. Discretionary debt often comes from what I call the institutional imperative. In this case it is displayed as management wanting to grow the business by making as many acquisitions as possible at the expense of considered analysis and ultimately the shareholders.
JP: We had some really extreme cases in Australia. For example, the debt to equity ratio of Babcock and Brown in December 2007 was 450 percent. Within months the company was in serious trouble and eventually it folded. I carried out a study on stocks on the ASX. It showed that companies that had debt to equity below 50 percent outperformed companies that had debt to equity above 50 percent by an average of 6.75 percent per year.
WB: I am not surprised. Getting rid of stocks with a high debt is part of the process of turning a speculative, low performing portfolio into one that is stable and high-performing.
JP: What about qualitative requirements?
WB: The first of these is to stay within your own circle of competence. Some time back I said, “The most important thing in terms of your circle of competence is not how large the area of it is, but how well you have defined the perimeter.” Investing in companies that you don’t understand or don’t support their products doesn’t make sense. You don’t have to know the minute details. But at least you should be able to describe in general terms what they do and how they make their profits. You should also be able to describe the future risks of the business. Finally it is important to know the economic moat of the company in terms of its type, strength and durability.
JP: I have heard you talk about economic moats. What are they and what role do they play?
WB: Just like castles had moats around them for protection, then ideal companies have moats that protect their business performance. Instead of physical moats, these moats consist of brand names, intellectual property and regional dominance. Instead of protecting against invading armies, economic moats protect the sales and profits against competitors, changes in consumer preferences, and even a weakening economy. Coca-Cola is an excellent example. The brand is so strong that every day millions of people ask for it by name.
JP: So far it looks like your secret consists of six parts: strong growth in earnings, consistent growth in earnings, high return on equity, not too much debt, stay with companies that you understand, and look for companies with a strong economic moat.
WB: These are the main points and provide a good start.
JP: But when I find these companies, how do I know how much to pay? I have heard you say that you can pay too much for even the best of companies.
WB: [Scraping the last of the chocolate sauce from his bowl] That’s right. People do a whole lot of work finding ideal companies and then go and pay prices that make it almost impossible to make a profit. But I have to go now. I’ve got an appointment to partner Bill Gates in a game of on-line Bridge. Let’s meet tomorrow at the same time and I’ll tell you how to estimate the return you’ll get when you make a purchase. Also I’ll explain how to analyse the risks of a business. On this point, this is one of the reasons why Charlie and I have been so successful as a team. We have each other to help understand the future risks associated with businesses. What one of us misses, the other one is likely to pick up. Also tomorrow we can talk about the idea of a margin of safety which Benjamin Graham introduced over 70 years ago. He said back then it was the most important idea in investing and I agree.
To be continued…
Professor John Price – Team Invest