SUPER INVESTING THE WARREN BUFFETT WAY

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SUPER INVESTING THE WARREN BUFFETT WAY
Great Caesar's Ghost Kent, are you telling me I
can actually earn double digit returns?
Hey Lois, learn how to invest and you wont have
to worry about working at the Daily Planet the
rest of your life!
Yes Perry, thats right
Jeepers Superman you really can invest
Superman HELP the Market is falling!!!
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Buffettology 101 The Wisdom of Warren Buffett

• As far as I am concerned,
• the stock market doesnt
• exist. It is there only as a
• reference to see if anybody
• is offering to do anything
• foolish.
• 
  Warren
  Buffett

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Understanding the Influence of Ben Graham on
Warren Buffett Through the Story of Mr. Market

• Long ago Ben Graham described the mental attitude
  toward market fluctuations that I believe to be
  most conducive to investment success. He said
  that you should imagine market quotations coming
  from a remarkably accommodating fellow named Mr.
  Market who is your partner in a private business.
  Without fail, Mr. Market appears daily and names
  a price at which he will either buy your interest
  or sell you his. Even though the business that
  the two of you own may have economic
  characteristics that are stable, Mr. Markets
  quotations will be anything but stable. For, it
  is sad to say, Mr. Market is a fellow who has
  incurable emotional problems. At times he falls
  euphoric and can see only the favorable factors
  effecting the business. When in that mood, he
  names a very high buy-sell price because he fears
  that you will snap up his interest and rob him of
  imminent gains. At other times he is depressed
  and can see nothing but trouble ahead for both
  the business and the world. On these occasions
  he will name a very low price, since he is
  terrified that you will unload your interest on
  him.

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Ben Graham and Mr. Market Continued

• Mr. Market has another endearing characteristic
  He doesnt mind being ignored. If his quotation
  is uninteresting to you today, he will be back
  with a new one tomorrow. Transactions are
  strictly at your option. Under these conditions,
  the more manic-depressive his behavior, the
  better for you.
• But, like Cinderella at the ball, you must heed
  one warning or everything will turn into pumpkins
  and mice Mr. Market is there to serve you, not
  to guide you. It is his pocketbook, not his
  wisdom, that you will find useful. If he shows
  up someday in a particularly foolish mood, you
  are free to either ignore him or to take
  advantage of him, but it will be disastrous if
  you fall under his influence. Indeed, if you
  arent certain that you understand and can value
  your business far better than Mr. Market, you
  dont belong in the game. As they say in poker,
  If youve been in the game 30 minutes and you
  dont know who the patsy is, youre the patsy.

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Who is Warren Buffett?

• Warren Edward Buffett was born August 30, 1930,
  in Omaha, Nebraska. He is the son of Howard and
  Leila Buffett. Howard Buffett, a long-time
  resident of Omaha, was a local stockbroker and
  Republican congressman. As a boy, Warren Buffett
  was fascinated with numbers. He easily could
  keep track of mathematical calculations in his
  head. At age eight, Buffett began reading his
  fathers books on the stock market.
• When Buffett lived in Washington, D.C., while his
  father served in Congress, his interests turned
  entrepreneurial. At age thirteen, Buffett worked
  two paper routes, delivering the Washington Post
  and the Washington Times-Herald. Back in Omaha,
  with his savings, he acquired reconditioned
  pinball machines for 25 each and placed them in
  local barbershops. Soon Buffett owned seven
  machines and was taking home 50 a week. Later,
  with a high school friend, Buffett bought a 1934
  Rolls Royce for 350 and rented it out for 35 a
  day. By the time he graduated from high school
  at sixteen, Buffett had saved 6,000.

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Who is Warren Buffett?

• While in his senior year at the University of
  Nebraska, Buffett read Benjamin Grahams classic
  book, The Intelligent Investor. This treatise on
  investing so influenced Buffett to the extent
  that, after receiving his college degree, he left
  his hometown of Omaha and traveled to New York to
  study with Ben Graham at the Columbia Graduate
  Business School. After graduating from Columbia
  with a masters degree in economics, Buffett
  returned to Omaha to serve a brief stint in his
  fathers brokerage firm. During this period,
  Buffett stayed in contact with his former teacher
  by writing to him about various investing ideas.
  In 1954, at Grahams invitation, Buffett moved to
  New York and joined the Graham-Newman
  Corporation. During his tenure at Graham-Newman,
  Buffett became fully immersed in his mentors
  investment approach.

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Investment Wisdom

• Dont try to buy at the bottom and sell at the
  top. This cant be done - except by liars.
  Bernard Baruch
• Fools and greed usually go hand in hand, which
  creates a field of opportunity for the rational
  man.
• Warren Buffett

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Investment Wisdom

• When it comes to risk, weve done better by
  avoiding dragons rather than by slaying them.
• Warren Buffett
• Traditional Wisdom can be long on tradition and
  short on wisdom.
• Warren Buffett

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Investment Wisdom

• Investing is the greatest business in the world
  because you never have to swing. You stand at
  the plate the pitcher throws you GM at 47! U.S.
  Steel at 39! Coke at 48! And nobody calls a
  strike on you. Theres no penalty except
  opportunity. All day you wait for the pitch you
  like then, when the fielders are asleep, you
  step up and hit it.
• Warren Buffett

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Investment Wisdom

• Buffett on Business Value We bought all of our
  Washington Post Co. holdings in mid-1973 at a
  price of not more than one-fourth of the then
  per-share business value of the enterprise.
  Calculating the Price/Value ratio required no
  unusual insights. Most security analysts, media
  brokers and media executives would have estimated
  WPCs intrinsic business at 400 to 500 million
  just as we did. And its 100 million stock
  market valuation was published daily for all to
  see. Our advantage, rather, was attitude We had
  learned from Ben Graham that the key to
  successful investing was the purchase of shares
  in good

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Investment Wisdom

• businesses when market prices were at a large
  discount from underlying business values. Most
  institutional investors in the early 1970s
  regarded business value as of only minor
  relevance when they were deciding the prices at
  which they would buy or sell. This now seems
  hard to believe. However, these institutions
  were then under the spell of academics at
  prestigious business schools who were preaching a
  newly fashioned theory The stock market was
  totally efficient, and therefore, calculations of
  business value were of no importance in
  investment activities. We are enormously
  indebted to those academics What could be more
  advantageous in an intellectual contest than to
  have opponents who have been taught that thinking
  is a waste of time.

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Buffett on Growth and Value

• Most analysts feel they must choose between two
  approaches customarily thought to be in
  opposition value and growth. Many
  investment professionals see any mixing of the
  two as a form of intellectual cross-dressing. We
  view that as fuzzy thinking in which, it must be
  confessed, I myself engaged some years ago. In
  our opinion, the two approaches are joined at the
  hip growth is always a component in the
  calculation of value, constituting a variable
  whose importance can range from negligible to
  enormous and whose impact can be negative as well
  as positive.

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Buffett on Growth and Value

• In addition, we think the very term value
  investing is redundant. What is investing if
  it is not the act of seeking value at least
  sufficient to justify the amount paid?
  Consciously paying more for a stock than its
  calculated value--in the hope that it can soon be
  sold for a still-higher price--should be labeled
  speculation which is neither illegal, immoral
  nor, in our view, financially fattening.
  Whether appropriate or not, the term value
  investing is widely used. Typically it connotes
  the purchase of stocks having attributes such as
  a low ratio of price to book value, a low P/E
  ratio, or a high dividend yield.

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Buffett on Growth and Value

• Unfortunately, such characteristics, even if they
  appear in combination, are far from determinative
  as to whether an investor is indeed buying
  something for what it is worth and is therefore
  truly operating on the principle of obtaining
  value in his investments. Correspondingly,
  opposite characteristics--a high P/E ratio, price
  to book and low dividend yield--are in no way
  inconsistent with a value purchase. Similarly,
  business growth, per se, tells us little about
  value. Its true that growth often has a
  positive impact on value. But such an effect is
  far from certain. For example investors have
  poured money into the domestic airline business
  to finance profitless growth.

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Investment Wisdom

• On Leaving Management Alone
• At Berkshire we dont tell .400 hitters how to
  swing.
• Warren Buffett

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Warren Buffett on taking Your Time

• An investor should act as though he/she had a
  lifetime decision card with just twenty punches
  on it. With every investment decision his card
  is punched, and he/she has one fewer available
  for the rest of his/her life. Warren Buffett

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Warren Buffett-the Sage of Omaha

• Buffetts Four Steps to Investing
• 1. Turn off the stock market.
• 2. Dont worry about the economy.
• 3. Buy a business, not a stock. Change your
  perspective to that of a business owner and
  learn as much as possible about the business and
  industry.
• 4. Manage a portfolio of businesses. Dont
  diversify for diversifications sake.

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Buffett on Diversification

• You cant be a Bo Jackson in investing. Spread
  your energies and your capital too many ways, and
  you are courting disaster. If you have really
  taken your time and only picked stocks that are
  bona-fide doozies, theres no need to diversify
  for safety. If youre not supremely confident
  about the future of each stock in your small
  portfolio, perhaps you should never have invested
  in it. Remember, the fewer stocks you have, the
  more time you can spend becoming an expert in
  them. You should never own more than ten stocks.
• We dont believe in the Noahs Ark principle of
  investing, winding up with two of everything.
  Then you have a zoo.

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Buffett on the Ideal Investor Personality

• The most important quality for an investor is
  temperament, not intellect. You dont need tons
  of IQ in this business. You dont have to be
  able to play three-dimensional chess or duplicate
  bridge. You need a temperament that derives
  great pleasure neither from being with the crowd
  nor against the crowd. You know youre right,
  not because of the position of others but because
  your facts and your reasoning are right.

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BERKSHIRE HATHAWAY INC.
Acme Brick Company Johns Manville Ben Bridge
Jeweler Jordan's Furniture Benjamin Moore
Co. Justin Brands Berkshire Hathaway
Group Larson-Juhl Berkshire Hathaway Homestates
Companies McLane Company Borsheim's Fine
Jewelry MidAmerican Energy Holdings
Company Buffalo NEWS, Buffalo NY MiTek
Inc. Central States Indemnity Company
National Indemnity Company Clayton Homes Nebraska
Furniture Mart CORT Business Services NetJets CTB
Inc. The Pampered Chef Fechheimer Brothers
Company Precision Steel Warehouse,
Inc. FlightSafety RC Willey Home
Furnishings Fruit of the Loom Scott Fetzer
Companies
Garan Incorporated See's Candies GEICO Auto
Insurance Shaw Industries General Re Star
Furniture Helzberg Diamonds United States
Liability Insurance Group H.H. Brown Shoe
Group Wesco Financial Corporation International
Dairy Queen, Inc. XTRA Corporation
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Buffettology 101 - Learning NOT to Play the
Market

• Dont be interested in the latest fades in the
  stock market.
• The vast majority of investors, including mutual
  fund investors, are short-term oriented they buy
  on good news and sell on bad news. You should do
  just the opposite.
• The short-term stock market mentality sometimes
  undervalues the long-term prospects of a great
  business.
• Buy on bad news.
• You must be able to grasp other peoples
  ignorance about the long-term economic worth of
  certain businesses.
• Adapted from The New Buffettology, by Mary
  Buffett and David Clark, Chapter 1.

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Buffettology 101 - Making Profits from Bad News

• Practice a selective contrarian investment
  strategy. This is one in which the investor is
  motivated to invest by a falling stock price.
  Contrarians invest in what the market finds
  unattractive.
• Recognize that the majority of investors play the
  short-term investment game.
• People sell on bad news.
• Companies that have a franchise product and thus
  a competitive advantage, have the economic power
  to weather most bad-news storms.
• Always invest in companies with a long-term
  durable competitive advantage, which we call a
  franchise product. A product characterized by
  few or no substitutes, a product in demand by
  many, little or no government regulation.
• Adapted from the New Buffettology

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Buffettology 101 - The Interplay between
Profits and Inventory Turnover

• The best kind of business to own is one with high
  profit margins and high inventory turnover.
• The second best kind of business to own is one
  with either high profit margins or a high enough
  inventory turnover.
• Stay away from a business with both low profit
  margins and low inventory turnover.
• Stay away from commodity-type businesses such as
• - Steel Producers - Airlines
• - Gas and Oil Companies - Auto manufacturers
• - Memory-chip producers - Paper manufacturers
• Adapted from the New Buffettology.

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Buffettology 101 - The Kind of Business to
Invest In

• Focus on the competitive advantage and the
  durability of that advantage.
• Competitive Advantage is created by producing a
  unique product or a unique service.
• Examples Coca Cola, Harley Davidson, Wrigleys
  Gum.
• Adapted from the New Buffettology

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Buffettology 101 - Creating the Franchise Product

• The Franchise Product has (is)
• A Durable Product with a Competitive Advantage.
• In high demand by a large segment of the market.
• Little or no close substitutes.
• Little or no Government regulation.
• Adapted from the New Buffettology

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Buffettology 101 - The Kind of Business to
Invest In

• Durable means that the business must be able to
  keep its competitive advantage well into the
  future without having to expend great sums of
  capital to maintain it.
• A low-cost competitive advantage is important for
  two reasons First is the predictability of the
  future earning power. Second, it improves the
  chances the business can expand shareholders
  fortunes rather than having to expend capital.
• Adapted from the New Buffettology

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Buffettology 101 - The Kind of Business to
Invest In

• The key to investing is not to focus on how much
  a business is going to change society, but
  instead focus all your energy on determining the
  competitive advantage of the company and the
  durability of that advantage.
• The two types of competitive advantage are
  created by producing a unique product and by
  providing a unique service.
• The key is that the product or service have
  durability.
• Some companies (Intel) have a competitive
  advantage based on intellectual talent and a
  large capital base, but manufacture products that
  have a short life span in the marketplace. These
  types of companies may have a competitive
  advantage, but they do not manufacture a product
  that has a durable competitive advantage.
• Adapted from the New Buffettology

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Buffettology 101 - Determining the Market Cap

• The Market Cap represents the total capitalized
  value of a firm. It is obtained by multiplying
  the current market price of the firm times the
  number of share outstanding.
• Suppose a company is currently selling at
  50/share and has 100 mil. Shares outstanding.
  The market cap would be 5 billion. If I require
  a rate of return of say 15, then this company
  would have to have earnings of 750 mil. What
  are the prospects for this?
• Adapted from the New Buffettology

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Buffettology 101 - Capitalizing on the Market Cap

• If a business earned 100,000 per year, year
  after year, what would you be willing to pay for
  it? If you required 15 return you would be
  willing to pay 666,667. If your rate of return
  were higher, you would be willing to pay less for
  the company, and if your rate of return were
  lower than 15 you would be willing to pay more.
• Lesson here is that higher interest rates make
  business earnings (and the business) worth less
  resulting in lower stock prices. Lower interest
  rates make business earnings (and businesses)
  worth more which results in a higher stock price.
• Adapted from the New Buffettology

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Buffettology 101 - Bull and Bear Market Cycles

• When to Buy Stocks The buy side of the
  selective contrarian investment strategy is made
  up of two parts
• The first step is to identify a company with a
  durable competitive advantage.
• The second step is to identify the right price at
  which to make the purchase.
• Market Cycles Certain types of markets,
  industry, and business conditions provide
  situations that provide buying opportunities for
  companies that have a competitive advantage.
  These conditions include market cycles, industry
  recessions, individual company calamities,
  structural changes, and war.
• Adapted from the New Buffettology

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Buffettology 101 - Bull and Bear Market Cycles
Bear Markets True Bear Markets devastate stock
prices across the board. They also offer the
possibility of terrific buying opportunities.
Once a Bear market is universally proclaimed
investors tend to over-react and become too
pessimistic, this is when opportunity comes
knocking. The bull market of the 1990s bubbled
in 1999 and burst in 2000, causing the bear
market of 2001. Bear markets appear
approximately every six years. The secret to
knowing when to invest is to be fearful when
others are greedy and greedy when others are
fearful. Key Point During a bear market it is
possible to find some spectacular buys on very
good companies with durable competitive
advantages.
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Buffettology 101 - Bull and Bear Market Cycles
Transition from Bear to Bull A Bull market comes
to fruition after an economic recession and after
the bear market has devastated stock prices.
During a Bear market, many good stocks trade with
P/E ratios in single digits. Momentum investors
get killed in a bull market because they have
invested in stocks that had continued to go up
until the bear hits. A bear market also brings
back the general contrarian and value-oriented
investor. Money managers who follow this
strategy are hired by mutual funds to replace the
momentum investors who got killed when stock
prices sank. The Value investors often buy
stock for below book value. As the Fed begins to
lower interest rates, corporate earnings and
hence corporate caps begin to increase.
Investors and momentum investors see stock prices
rise and then jump in on the action, which starts
the cycle all over again. Adapted from the New
Buffettology
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Buffettology 101 - Bull and Bear Market Cycles
The Bull Market Once interest rates are lowered
and stock prices increase, more and more
investors begin getting back into the market,
including mutual funds. Seeing spectacular
results in the neighborhood of 20 to 30,
investors respond by taking their money out of
low-interest, money-market accounts and start
buying mutual funds. The momentum
investor/mutual fund manager reappears in a big
way and begins the drama all over
again. Corrections and Panic Selling Then the
market suffers a correction (perhaps in October)
and goes through a short period of panic selling.
These provide perfect buying opportunities for
the selective contrarian investor. You must act
quickly and with great conviction to take
advantage of these opportunities.
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Buffettology 101 - Bull and Bear Market Cycles
The Top of the Bull Market Bull markets can run
on for years. When stock market analysts and
media pundits proclaim that earnings are no
longer important in valuation, the bull market is
in its final phase. This is where it begins to
bubble. P/E ratios start going up from single
digits to the teens and then the twenties, then
thirties, forties, and fifties. Valuations are
now based on total sales and revenues instead of
P/E ratios. The result is that even businesses
that dont have earnings see their share prices
soar. Most recently it happened in the late
1990s. At this point the vast majority of fund
managers have been pushed into playing a momentum
game. The bubble is about to burst when you read
that value-oriented fund managers are quitting
the business because they cant compete with
momentum-fund managers. Adapted from the New
Buffettology
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Buffettology 101 - Bull and Bear Market Cycles
The Bubble Bursts Rising interest rates, a shift
from earnings to revenue in valuations,
value-oriented fund managers being driven from
the game, and a split market in which some
industries get creamed and others continue to
soar spell impending disaster. If you are in the
hot segment, you should call it quits, sell out,
and go shopping in the unpopular segments. The
Aftermath After the bubble bursts, a couple of
things can happen. The first is recession. The
Fed will drop interest rates which take 12-18
months to begin reviving the economy. Do not buy
or sell stocks based on what you think the market
will do. Be a price-motivated investor. Adapted
from the New Buffettology
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Buffettology 101 - Five Situations that
Create Buying Opportunities

• Stock Market Correction or Panic
• Industry Recession
• Individual Business Calamity
• Structural Changes
• War
• Adapted from the New Buffettology

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Buffettology 101 - Five Situations that
Create Buying Opportunities
Industry Recessions An industry recession can
lead to serious losses or can mean nothing more
than a mild reduction in EPS. Recovery time is
normally 1-4 years. Dont be fooled by a selling
price that appears too cheap. Stay with a
well-capitalized leader, on that was very
profitable before the recession.Remember that the
market over-reacts to bad news and punishes
companies (good and bad) with lower stock
prices. Example The banking industry recession
of 1990 provided the opportunity to invest in
Well Fargo. Due to a recession in the real
estate market. Wall Street hammered Wells Fargo
stock down to 41.30 from 86. Wells Fargo lost
52 of its share price because it was not going
to make any money in 1991. Buffett bought 5
million shares, and by 2001 the price per share,
accounting for splits, was approximately 270.
Adapted from the New Buffettology
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Buffettology 101 - Five Situations that
Create Buying Opportunities
Individual Calamity Sometimes brilliant
companies do stupid things and lose big money.
Most of the time the market will slam the stock
price. Your job is to figure out whether this
situation is a passing calamity or irreversibly
damaging. Example In 1999 Mattel acquired the
Learning Company. Mattel consistently lost cash
to the point that it sent the stock price from a
high of 46 a share in 1998 to a low of 9 in
2000. This created a buying opportunity since
Mattels main product line, Barbie, continued to
do an excellent business. Buffett bought Mattel
stock for 9-10. By the spring of 2001,
Mattels share price was at a healthy 18/share,
roughly returning 100. Adapted from the New
Buffettology
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Buffettology 101 - Five Situations that
Create Buying Opportunities
Structural Changes Structural changes in a
company can often produce special charges against
earnings that have a negative impact on share
price. Mergers, restructuring, and reorganizing
costs can have a very negative impact on net
earnings, which translates into a lower share
price, which could mean a buying
opportunity. Examples Buffett invested in Costco
after it had suffered negative earnings due to
merger and restructuring costs. He also invested
in Tennaco Offshore and Service Master based on
these companies converting from corporate form
to a master partnership. Buffets investment in
Sears was based on the announcement that it would
spin off its insurance division, Allstate.
Adapted from the New Buffettology
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Buffettology 101 - Five Situations that
Create Buying Opportunities
The War Phenomenon The threat of war will send
stock prices downward regardless of the time of
year.The uncertainty and potential for disaster
presented by any major armed conflict will kill
the market. The ensuing sell-off is strictly
motivated by outright fear, which results in
people selling stocks and hoarding cash, which in
turn, disrupts the economy. The 2001 war in
Afghanistan and the subsequent war in Iraq sent
stock prices tumbling and created fantastic
buying opportunities. Many industries such as
Airlines, car rental agencies, hotels, travel
companies, and cruise lines all saw their stock
prices decimated as a result of a massive
disruption of the travel industry. People simply
stopped traveling, for a while. There may be a
few permanent casualties, but there will also be
opportunity to buy good companies. You have to
do your homework. - Adapted from the New
Buffettology
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Buffettology 101 - 4 Types of Companies with
Durable Advantage
1. Businesses that fulfill a repetitive
consumer need with products that wear out fast or
are used up quickly, that have brand-name appeal,
and that merchants have to carry or use to stay
in business. Examples of this would include
McDonalds Taco Bell, KFC, Campbell Soups,
Hershey Foods, Wrigleys, Coke, Anheuser-Busch,
Gillette, Levi Strauss, Nike, Liz Claiborne,
Harley Davidson. Adapted from the New
Buffettology
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Buffettology 101 - 4 Types of Companies with
Durable Advantage

• Advertising businesses, which provide a service
  that manufacturers must continuously use to
  persuade the public to buy their products. This
  is a necessary and profitable segment of the
  business world. Whether you are selling
  brand-name products or basic services, you need
  to advertise. Buffet examples include
  Interpublic, Ogilvy Group, Omnicom Group,
  Washington Post Company.
• Adapted from the New Buffettology

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Buffettology 101 - 4 Types of Companies with
Durable Advantage

• Businesses that provide repetitive consumer
  services that people and businesses are
  consistently in need of. This is the world of
  tax preparers, cleaning services, security
  services, and pest control. Buffett examples
  include Service Master, Rollins, which runs
  Orkin, H R Block. Cintas Corp. rents uniforms,
  dust mops, entrance mats, etc., Dun Bradstreet,
  InfoUSA.
• Adapted from the New Buffettology

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Buffettology 101 - 4 Types of Companies with
Durable Advantage

• Low-cost producers and sellers of common products
  that most people have to buy at some time in
  their life. This encompasses many different
  kinds of business from jewelry to furniture to
  carpets and insurance.
• Adapted from the New Buffettology

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Hersey Food's An Example
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• Doing the Analysis
• Does Hershey have identifiable consumer
  monopolies or brand name
  products, or does it produce or sell a commodity
  product?
• Do you understand how it works?
• Is the company conservatively financed? In order
  to answer this consider the debt ratios. In the
  year 2000, Hershey had a total debt/total asset
  ratio of .75. This is high in comparison to the
  industry and to our threshold of 30.
• Are the earnings of Hershey strong with an upward
  trend? EPS for Hershey has gone from 1.22 to
  2.39 from 1991 to 2000, a annual growth 7.

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• 5. Does the company allocate capital only to
  businesses within its realm of expertise? Answer
  here is yes.
• Has the company been buying back its shares?
  Yes!
• Does managements investment of retained earnings
  appear to have increased per share earnings and
  therefore shareholder value? Actually, during
  the last two years the Market Value Added was
  negative. However, over the last 10 years the
  MVA is 2.16 for every 1 retained.
• Is the companys return on equity above average?
  Yes, over the last 10 years, Hershey has averaged
  26.4.

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• Is the company free to adjust prices to
  inflation? Hershey has adjusted prices and the
  size of its products over the years to
  compensate for inflation. People will not stop
  buying chocolate during inflationary time.
• Are large capital expenditures required to
  constantly update the companys plant and
  equipment? No.

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Buffets Tenets of Investing

• 1. Is the business simple and understandable.
  Does the company have an identifiable durable
  competitive advantage?
• 2. Does the business have an identifiable
  consumer monopoly or franchise product? What is
  the chance the product will become obsolete in
  the next 20 years?
• 3. Does the business have a consistent
  operating history over time. Are earnings (net
  income) increasing and is the ROE consistently
  high (25-30).
• 4. Does the business have favorable long-term
  prospects? Is it a franchise or least cost
  commodity producer? Look for Goodwill.
• Invest within your circle of competence. Its
  not how big the circle is that counts, its how
  well you define the parameters. Warren Buffett
• When management with an excellent reputation
  meets a business with a poor reputation, it is
  usually the businesss reputation that remains
  intact. Warren Buffett

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Buffets Tenets (Cont.)

• 5. Does the company allocate capital
  exclusively in the realm of its expertise?
• 6. Is management rational? Does the management
  use excess cash to buy back stock and issue
  dividends, or expand company into low return
  investments. Does management express that they
  are committed to the best interests of the
  shareholders total return on investment.
• 7. Is management candid with its shareholders?
  Does management do things the way that everyone
  else does or do they think and look at their
  environment before doing things?
• Business schools reward complex behavior more
  than simple behavior but simple behavior is more
  effective. Warren Buffett

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Buffetts Tenets (Continued)

• 8. Does the Company have less than 30 debt?
• 9. How much does the business have to spend on
  maintaining operations (check out operating
  ratios).
• 10. Can the Company adjust prices during
  inflation?
• Our favorite holding period is forever. --
  Warren Buffett
• The Margin of error is the cornerstone of our
  investment philosophy Never count on making a
  good sale. Have the purchase price be so
  attractive that even a mediocre sale gives good
  results. - Warren Buffett.
• A great investment opportunity occurs when a
  marvelous business encounters a onetime huge but
  solvable problem. - Warren Buffett.

52
Buffetts Tenets

• 11. Focus on return on equity, not earnings per
  share. EPS is meaningless, since the equity base
  can expand over time due to increased retained
  earnings. Therefore, EPS does not necessarily
  reflect good managerial performance.
• 12. Calculate owner earnings. Seek out
  companies that produce excess cash. Owner
  earnings is equal to net income plus
  depreciation, depletion, and amortization, minus
  capital expenditures necessary to maintain its
  economic position and unit volume.
• Id rather have a 10 million business making
  15 than a 100 million business making 5. I
  have other places I can put the money. Warren
  Buffett
• We like to buy Businesses, but we dont like to
  sell them. Warren Buffett

53
Buffetts Tenets

• 13. Look for companies with high profit
  margins. Companies with tenacious cost-cutters.
  Remember companies with high costs will always
  come up with new ways to spend more.
• 14. For every dollar retained, make sure the
  company has created at least three dollars of
  market value. Calculate the retained earnings
  to market value ratio (use a 10 year trend).
  Dollar created/Dollar retained.

54
Buffetts Tenets

• 15. What is the value of the business? The
  cash flows of a business discounted back to
  todays present value determines the intrinsic
  value. Discounted by the long-term treasury rate
  plus 2 to 4 depending on your risk preference
  (Buffett uses 15).
• 16. Can the business be purchased at a
  significant discount to its value? Look at the
  stock price. Can you purchase the stock at a
  significant discount to the stock price. The
  greater the difference, the greater the allowance
  for a margin of error. (At least 50).
• It is far better to buy a wonderful company at a
  fair price than a fair company at a wonderful
  price. Warren Buffett

55
Buffets Tenets

• Buffetts Yearly Check-up
• - Calculate return on beginning shareholders
  equity
• - Check the changes in operating margins, debt
  levels, and capital expenditures
• - Check the companys cash generating ability

56
Financial Calculations Predictability of Earnings

• Four types of Earning situations
• 1. Consumer Monopoly Type Business
• Year EPS
• 2002 1.07
• 2003 1.22
• 2004 1.36
• 2005 1.52
• 2006 1.76
• A Consumer Monopoly Type Business will have
  predictable earnings. Also check the growth in
  total earnings over the same time period.

57
Financial Calculations Predictability of Earnings

• Four types of Earning situations
• 2. Commodity Type Business
• Year EPS
• 2002 1.57
• 2003 0.16
• 2004 -1.28
• 2005 0.42
• 2006 -.023
• A Commodity Type Business has earnings that are
  all over the place with no apparent trend. If
  something smells fishy it usually is.

58
Financial Calculations Predictability of Earnings

• Four types of Earning situations
• 3. Possible Consumer Monopoly
• Year EPS
• 2002 1.07
• 2003 1.22
• 2004 1.36
• 2005 1.52
• 2006 0.48
• The Possible Consumer Monopoly appears to have
  strong consistent growth until 2006. Is this an
  aberration or a sign of things to come?

59
Financial Calculations Predictability of Earnings

• Four types of Earning situations
• 4. Possible Consumer Monopoly in Trouble
• Year EPS
• 2002 -1.07
• 2003 1.22
• 2004 1.36
• 2005 1.52
• 2006 -0.48
• The Possible Consumer Monopoly may be in
  trouble.
• The problem may stem from a one time problem
  that lands the firm out of favor on Wall Street.
  Check out the reasons for the negative returns.

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Calculating the Initial Rate of Return

• You must take a business perspective when
  investing. If you pay 25 for a share of stock
  and it earns 5, then your rate of return is
  5/25, which is equal to a 20 return. This
  calculation is the Return on Investment on Screen
  1 of the Excel Spreadsheets.

61
Calculating the Growth Rate in EPS

• Use your calculator and the data below to
  calculate the growth rate
• Year EPS
• 2002 1.07
• 2003 1.22
• 2004 1.36
• 2005 1.52
• 2006 1.76
• PV -1.07 FV 1.76 n 5 COMP i 10.5
• Check out row 35 of Screen 1 on the Excel
  Spreadsheets

62
The Concept of an Equity/Bond with a Growing
Coupon

• Warren Buffett views a stock as an equity bond
  that has a growing coupon. While most bonds have
  a fixed coupon, a stock can be viewed as a bond
  that has both a changing principal value and a
  growing coupon (net earnings) over time. But
  unlike fixed coupons on corporate bonds, stocks
  should be paying the holder a greater coupon
  payment each year the investor holds it. While
  the investor who holds the fixed bond receives
  his/her interest each year, the investor receives
  their earnings on a stock (usually in the form of
  dividends or increased stock price).

63
Using the Earnings growth rate to Project the
Companys annual rate of return

• In the case of Johnson and Johnson from our excel
  spreadsheets, we have the following earnings
  values
• 1996 1997 1998 1999 2000 2001 2002
  2003
• 2,887 3,303 3,678 4,209
  4,800 5,885 6,811 7,197
• To calculate the annual growth in earnings over
  this time period use your calculator
• PV -2887 n 7 FV 7197 comp i 13.9

64
Why Stock Repurchase Programs Increase Investor
Wealth

• Lets say that a company has 100 million shares
  and you own 10 million, which is 10 of the
  business. Lets say the company buys back 40
  million shares, it will have 60 million
  outstanding. Your ownership interest would be
  16.6 now (10/60). Now lets assume that the
  total CAP of the company is 800 million. Our
  original stake of the business would have been
  worth 80 million. Now, if the CAP remains the
  same, our stake is worth 132.8 million. The
  company has increased our net worth by 52.8
  million. Check line 14 of Screen 1 to see if
  your total number of shares outstanding is
  increasing or decreasing.

65
Measuring Managements Ability to Maximize
Retained Earnings

• A consumer monopoly will always do a better job
  of getting a greater return on retained earnings
  than will a commodity type business. Therefore,
  you should always measure the firms return on
  its retained earnings based on the additional
  earnings that it generates over the analysis
  period. See line 58 of Screen 1 in the excel
  spreadsheets. Compare this rate of return to the
  value added on line 49.

66
Assignment

• Read the Masters document on the Web site.
• Begin looking for a company to analyze using the
  criteria given in class and the information in
  these overheads.