Chapter 7

Using Warren's Investment Methods to Avoid the Next High-Tech Massacre

Now that you have Warren's concept of durability in your head, let's diverge from our path for a
moment and discuss why Warren doesn't invest in transforming industries like the Internet.

Warren believes that many investors get caught up in the visions of grandeur that accompany
new industries that promise to reshape and transform society. Other transforming industries have
caught investors' imaginations -- the radio, automobile, airline, and biotech industries. All
sparked investors' dreams of immediate wealth, which in turn caused a massive run-up in share
prices as the investing public went wild pumping money into them. This of course created higher
share prices, which vindicated the investors' decisions and serves as an enticement to invest even
more. Many people see others getting rich and they too join the game, which sends stock prices
soaring even higher. This process often continues until economic reality is left far behind. But it
can't go on forever, for economic reality is like gravity. At some point the bubble bursts and
stock prices fall.

From 1919 to 1939 alone, more than three hundred airline manufacturers came and went. Fewer
than ten survive today. And what about their brethren the airlines? In the past twenty years, 129
carriers have filed for bankruptcy. In fact, until 1992, the total amount lost by airlines that went
bankrupt was far greater than the total they made. The Internet carnage is equally sobering --
hundreds of these companies, some that once commanded $100 or more a share, have become
nothing but bitter memories in the minds of their shareholders.

For Warren, the problem with transforming industries is that they seldom, if ever, establish any
kind of durable competitive advantage due to the intense competition that exists in the infancy of
any industry. Intense competition equates of course to lower profits, which ultimately kills a
soaring stock price. Also, in new industry sectors, businesses evolve through countless
permutations before establishing any kind of durable competitive advantage. That new
businesses by definition have no history of product durability -- one of the cornerstones of
Warren's selective contrarian investment philosophy -- is another strike against them.

Lack of durability keeps Warren from investing in these emerging industries on principle, but he
nevertheless likes to hypothetically consider purchasing such businesses whole. He believes that
if the entire company isn't worth purchasing at the current stock market price, he shouldn't even
buy one share. It is a unique way to look at a prospective investment and one that is shunned by
most of Wall Street.

To understand Warren's whole business approach you need to know how to calculate what is
called the company's stock market capitalization or, as it is commonly known, the company's
market cap.

The market cap is computed by multiplying the number of shares outstanding by the current
market price of one share of the company's stock. Let's say that Company X has 100 million
shares outstanding and is trading at $50 a share. The market cap for Company X would be $5
billion (100 million shares x $50 a share = $5 billion). If the price of Company X's stock dropped
the next day to, say, $45 a share, its market cap would drop to $4.5 billion (100 million shares x
$45 a share = $4.5 billion). Conversely the market cap would increase if Company X's stock
price went up.

When Warren considers whether to make an investment in Company X, he asks himself the
following questions: If the company in question had a market cap of $5 billion and I had $5
billion sitting in my bank account, would I use it to buy the whole company? What kind of return
would I get if I paid $5 billion for the company? If he finds the rate of return attractive, he will
invest in the company. Notice that he is not asking whether the stock price of the company will
go up. Rather, he asks how much will he likely earn given the price that he pays for the entire
business.

Let's run through an example. Suppose you were thinking about investing in Yahoo! back on
March 10, 2000. Its trading price at that time was $178 a share, and it had a market cap of
approximately $97 billion. The question would have been this: If you had $97 billion, would you
have been willing to spend it to buy the entire company?

Before you spent you $97 billion, you might just have looked over your other investment options
before forking over all that cash for a big ride on Yahoo!. The first thing you discover is that you
can invest your $97 billion in U.S. treasury bonds and get a 7% return, which means that you
would be earning approximately $6.7 billion a year in interest. Not bad. Compare this to the
$70.8 million that Yahoo! was expected to earn in 2000 and the treasury bonds look far more
enticing and enriching.

But say that you are a true believer in the Internet and think Yahoo! has a great future! Warren
would argue that this may be true, but if you buy all of Yahoo!, you are going to be giving up
$6.7 billion in yearly interest income in exchange for the $70.8 million a year that Yahoo! is
earning. You, in turn, argue that Yahoo! will earn great sums in the future. Warren would argue
that this may also be true. But for each future year you give up the $6.7 billion in interest
income, that's $6.7 billion more that Yahoo! is going to have to earn just to keep you even. After
even a few years, a billion here and a billion there start to add up. (To keep this in perspective, in
2000, Coca-Cola earned approximately $2.1 billion and General Motors earned approximately
$4.4 billion. It takes a hell of a business to generate $6.7 billion in earnings.) It doesn't take a
genius to see that buying all of Yahoo! might not be the smartest thing to do with your $97
billion. InWarren's mind it's a short step from there to the conclusion that buying a single share is
also a bad idea.

Compare our prospective investment in Yahoo! with an investment in insurance giant and
Buffett favorite Allstate. On March 10, 2000, during an insurance recession, Warren was
rumored to have been buying Allstate at approximately $18 a share. (As of this writing, this
rumor has not been confirmed. We shall assume it is true for the purposes of the hypothetical.)
Allstate in 2000 had 749 million shares outstanding, which gave it a market cap of $13.4 billion
(749 million shares x $18 a share = $13.4 billion.) It earned approximately $2.2 billion a year.
This means that if you spent $13.4 billion buying all of Allstate in 2000, so that you owned the
entire company, you would have earned $2.2 billion in income, which equates to approximately
16.4% a year on your money. This is a much better deal than you would have gotten by paying
$97 billion for Yahoo! to earn only $220 million, which equates to earning less than 1% a year
on your money. In fact, an investment in Allstate is a much better investment than Uncle Sam's
treasury bonds.

In truth it is doubtful that anyone other than Warren and a few financial titans are going to cough
up $97 billion for a company. We small frys are stuck buying fractional interests in these
companies. But remember, Warren believes that if it isn't worth buying the whole company, you
shouldn't even buy one share. He also believes that if it is worth buying the entire company, one
should buy as many shares as possible.

So suppose we invested $50,000 in Yahoo! on March 10, 2000. Let's also assume that on March
10, 2000, Warren invested $50,000 in Allstate when it was trading at $18 a share. By April of
2001, Yahoo! had dropped from $178 a share to $15 a share, giving us a loss of approximately
91%, reducing our $50,000 investment in Yahoo! to $4,215. The stock price dropped because
investors got tired waiting for the $6.7 billion in earnings to arrive. Remember, grim economic
reality can drag a stock price to the ground. If the earnings don't show up, investors don't either.

On the other hand, Warren's Allstate investment grew from $18 a share to $40, giving him a
122% return, increasing his $50,000 investment to approximately $111,111. Warren was in good
hands with Allstate because he wasn't buying pie in the sky, but real earnings at a price that made
business sense. (It is interesting to note that one of the reasons why Allstate was selling so cheap
was that everyone else was out chasing the fast bucks being made in Internet stocks. Investors'
money fled the old economy for the new economy. They didn't want to own a stodgy old
insurance company. The price of its shares went down and created Warren's rumored buying
opportunity.)

What keeps Warren from investing in transforming industries is a lack of a durable competitive
advantage, plus astronomical selling prices that don't make business sense given the economic
reality of the business. If doesn't make sense to buy the entire business, it doesn't make sense to
buy a single share no matter how sweet the pie looks.

WHAT YOU SHOULD HAVE LEARNED FROM THIS CHAPTER

* Lack of a historical durable competitive advantage keeps Warren from investing in emerging
industries.
* When Warren considers whether to make an investment in Company X, he asks himself the
following question: If the company in question had a market cap of $5 billion and I had $5
billion sitting in my bank account, would it be a wise use of my money to buy the whole
company?
* Warren likes to play a little game and pretend that he is going to buy the whole business. He
believes that if the entire company isn't worth purchasing at the current stock market price, he
shouldn't buy even one share.

Copyright © 2002 by Mary Buffett and David Clark



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