BUFFETT INVESTMENT METHODOLOGY

WBW: Chapters 1-3 and 10 and 12 WBP: Chapters 1-4

Focus Investing
Modern Portfolio Theory (MPT) encourages diversification to reduce risk. Buffett believes that the benefits of diversification are more than offset by the problems associated with managing large numbers of securities Buffett prefers to make large bets on a small number of companies in his circle of competence Buffett has dubbed this approach Focus Investing
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Wells Fargo 2007-2012

Finance.yahoo.com WFC Historical prices
Monthly data Jan 1, 2007 Dec 31, 2012
Also available on the Blackboard page

Wells Fargo
1. Sort the data (oldest to newest, A to Z) 2. Use the adjusted close column 3. Make a chart of the adjusted close from Jan 2007 Feb 2009 i. Add the monthly volume to this graph ii. Add a secondary axis 4. Calculate the monthly % return for each month 2007-2012 = 1 1 5. Calculate the value of $100,000 invested at the end of January 2009 each month to December 2012 = 1 1 + 6. Make a chart of your values in part (5) 7. Calculate your compound monthly return and annualize this number
=
1

= 1 +

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1
4

Use the COUNT function

Charlie Munger
Charlie Munger: Lessons From an Investing Giant August 30, 2013, page B1

Summary: In the first quarter of 2009, Charlie Munger invested 71% of the cash of a small publishing unit he chairs in bank stocks. Sources say the largest positions were in Wells Fargo and US Bancorp. Stock Wells Fargo Average annual Return 1Q2009 end 2012 18.57%

US Bancorp

Homework: Repeat the WFC example with US Bancorp (USB) data from Jan 2007-Dec 2012. Find the average monthly return and annualize the return. YOU MUST USE THE COUNT function!!!! Do this in groups of 2 or 3.

Lessons
What you can learn from Charlie:
Individual investors can be patient
You can sit on cash, professional money managers cannot

You can be brave and make bold moves

Especially if you are young How old is Charlie?
Charlies advice: Sit on your ass regardless of what the investment crowd is doing until a good investment finally materializes.

Lessons
How do you know when a good investment is available? From the WSJ article:
Most money managers spend their days in meetings, riffling through emails, staring at stock-quote machines with financial television flickering in the background, while they obsess about beating the market.

Mr. Munger and Mr. Buffett, on the other hand, sit in a quiet room and read and think and talk to people on the phone. By organizing their lives to tune out distractions and make fewer decisionsMr. Munger and Mr. Buffett have tilted their odds toward making better decisions.
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Educational Influences on Buffett

Benjamin Graham Partner in brokerage firm of Newburger, Henderson & Loeb by the time he was 25 he was making an annual salary of $600,000 (in 1919). Ruined in the 1929 crash taught night classes in finance at Columbia and (with David Dodd, a finance professor at Columbia), wrote Security Analysis (1934) and The Intelligent Investor (1949)
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Benjamin Graham
Introduced Buffett to the concept of Margin of safety Margin of safety is the difference between the intrinsic value of a company and the companys price. Suggested buying stocks selling for less than 2/3 of net asset value. (p. 15 WBW) Stock price should be less than net current assets Focus on low-P/E stocks
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Benjamin Graham
Approach focused on stocks deeply out-offavor with the market. Graham felt that market frequently mispriced stocks by overreacting to bad news. Early use of the concept of reversion to the mean Focused on statistics and bargain stocks little interest in management.
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Benjamin Grahams Stock Selection Rules for Defensive Investors

Adequate size not less than $100 million of annual sales for industrial companies and $50 million of assets for public utilities (1970) Strong Financial Condition 2:1 current ratio and long term debt < working capital Positive earnings for the common stock in each of the past ten years. Dividend payments in each of last 20 years. Minimum increase of at least 1/3 in per-share earnings in the past 10 years, using 3 year averages at the beginning and the end. Price <= 15 times the 3-year average of earnings per share. Current price < 1 times book value Price/Book Value x P/E < 22.5 11

Excel Exercise

BEN GRAHAM DEFINSIVE INVESTING WORKSHEET

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Philip Fisher
Started Fisher & Company in 1931 after graduating from Stanfords Graduate School of Business Administration. Suggested investing in firms with above-average potential and highly capable management. Looked at profit margins and ability to grow without external financing (as external financing would dilute existing stockholders ownership). Focus on integrity of management, depth of management and relationship between management and employees. Portfolios included fewer than 10 companies Extensive interviews with companies and competitors.
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John Burr Williams

PhD Dissertation at Harvard was The Theory of Investment Value introduced the concept of the dividend discount model. Buffett discounts owners earnings instead of dividends, and uses the 10-year government bond rate as the interest rate (or if interest rates are very low, the average cumulative return of the overall stock market).
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Charlie Munger
Grew up in Omaha Had a successful law practice in Southern California and also ran an investment partnership. Bought shares of Blue Chip Stamps and eventually became chairman of its board. Berkshire and Blue Chip Stamps merged in 1978 and he became Berkshires vice chairman. Now also chairman of Wesco Financial (80% owned by Berkshire). Believes in paying a fair price for quality companies. It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
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Berkshire as an Insurance Company

Read Chapter 3 on your own it discusses how Berkshires insurance business provides that cash that funds Berkshires investments. ($44.2 billion in 2003).

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Justification for Focus Investing

Golden Rules of Focus Investing (p. 160 WBW): Concentrate your investments in outstanding companies run by strong management Limit yourself to the number of companies you can truly understand. Pick the very best of your good companies and put the bulk of your investment there. Think long-term: five to ten years minimum Volatility happens. Carry on.
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Focus Investing (Cont.)

Modern Portfolio Theory (MPT) stresses diversification.
Harry Markowitz (1952) efficient frontier and riskreturn tradeoff and concept of covariance. Bill Sharpe (1963) concept of market risk (beta) Fama (1963) concept of efficient market

Buffett does not believe that investors always behave rationally (an assumption of MPT), and thus doesnt believe that the market is always efficient.
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Buffett on MPT
If prices are not always rational, measuring risk relative to the market may not be meaningful. Diversification reduces bad outcomes, but also reduces the chance of good outcomes thus insuring that you will get average outcomes with less variability. To beat the market, you need to be willing to accept more volatility. To achieve the maximum benefits from diversification, you must invest in lots of companies. It is likely that you will have to invest outside of your circle of competence and that you will not be able to fully understand and analyze each investment. Uses margin of safety concept to reduce risk, not calculations of beta and standard deviation. Makes big bets on high probability events instead of pursuing diversification.
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Buffett on MPT
Read the first part of Chapter 3 (WBP) on your own. Discusses results of successful focus investors Bill Ruane (Sequoia Fund), John Maynard Keynes, Charlie Munger and Lou Simpson (GEICO). Summarizes Buffett speech on efficient markets in 1984 at Columbia University.
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Focus Investing Statistics

Look at WBP p. 54-62 Randomly constructed portfolios of different sizes. Focus portfolios beat the market but had much higher volatility.

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