Lessons to investors and managers by Warren E. Buffett
My Key Learnings :-
Twitter: @shuchi_nahar
Book Name: A few Lessons to investors and managers -from from Warren E. Buffett
Book by : Peter Bevelin
CHAPTER 1 & 2
The price you pay, determines the return you will get.
According to Ben Graham, PRICE IS WHAT YOU PAY AND VALUE IS WHAT YOU GET.
The return then received, can be compared with expected return from other opportunity. The value of any stock, bond or business today is determined by the cash inflow and outflow that are discounted at an appropriate rate.
Individual needs to use the correct number, for example, proper discounting and that is the expected life of remaining assets.
Buffet has precisely mentioned the bitter truth about money that,
‘It doesn’t matter from where the cash comes from, because in the end it will all be spent.’
Financial asset that has the highest value in comparison to its price is the one that gives the highest return.
The investment that is derived from ‘Discounting Cash Flow’ is considered to be cheapest and the one investor should purchase.
Making an appropriate rough decision is better than making no decision. Due to this we would rather be approximately right than precisely being wrong.
Working with precise number is in fact foolish but one should work with wide range of possibilities that proves to be a better approach.
Despite intrinsic value being fuzzy as it’s just an estimate that depends on interest rate fluctuations, is all important and only the logical way to evaluate the relative attractiveness of investment and business.
CHAPTER 3
Bonds and stocks are similar to each other, the only difference being; that bond comes with coupon and maturity date which defines the future cash flow of bond, but for equities the investment analyst must himself estimate the future coupons.
The quality of management hardly affects the value of bond but it surely affects the value of equity.
Book value is almost unrelated to the intrinsic value of the business.
Book value is an accounting term that measures capital including retained earning that has been put into business, whereas intrinsic value is a present value estimate of the cash that can be taken out of a business during its remaining life.
For Example, consider a student’s Education cost to be book value , to make this cost accurate include the earnings that were foregone by student because he chose college and not job. Estimate earnings that the graduate will receive over his lifetime and subtract it from the amount that he would have earned skipping his college.
This will give an excess earning figure; now discount it with an appropriate interest rate back to graduation day. The result will be equal to the intrinsic economic value of education.
For some graduate they will find their book value of their education exceeds the intrinsic value means whosever paid for education didn’t get his money’s worth.
Intrinsic value of an education will far exceed its book value; if this happens then it implies that the capital was wisely deployed.
Book value is meaning less as an indication of intrinsic value.
The entire yardstick such as dividend yield ratio, price to earnings, book value and even growth rates have nothing to do with valuation except to the extent they provide clues to amount and timing of cash into and from the business.
Growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets generate in later years.
The investment shown by the discounted flows of cash calculation is considered to be cheapest and it is the one that investor should purchase without considering whether the business grows or doesn’t display volatility smoothness in earning or carries high prices or low in relation to its current earning and book value .
OWNERS EARNING:
- Reported earning
- Depreciation , depletion , amortization
- Average annual amount of capitalized expenditure
- It also includes those additional amounts which will be required for additional working capital to maintain its competitive position.
When an earning figure is accompanied by an unqualified auditor certificate in the end, the truth then is revealed in no matter of time.
Eventually truth will surface but in mean time a lot of money can change hands.
When management does such shenanigans, a base business cannot be transformed into a golden business by tricks of accounting or capital structure.
More money has been stolen with point of a pen than at a point of a gun.
Happening of many predictions will spread un-warranted optimism. Even more troublesome is the fact that they corrode the CEO’s behaviour.
Be wary of the managers who promise to make number, because at some point in time they will be tempted to make up the number.
Accounting shenanigans have a heavy ball of snow balling: Once a company moves earning from one period to another , operating shortfalls that occur thereafter require it to engage itself in the range of accounting frauds.
CHAPTER 4
To judge any company’s profitability there are three things to be determined.
What its asset earning
What its liabilities cost
Its utilization of leverage – the degree to which its assets are funded by liabilities than equity.
Any business who determines to outperform, should know the tactic of maintaining both sides of Balance Sheet, which means obtaining the highest possible returns on assets and lowest possible cost on liabilities.
The company that earns high returns on capital invested in the business; the more it generates cash, the more value is being generated. The company that has few tangible assets to operate the business is likely more cash rich. In capital intensive business, the cash flows are reduced in order to make investment just to keep the same unit volume and competitive position.
It is painful for investors to see that the company has to put every 1 dollar or so for the growth of the business.
- Return on invested capital is mainly determined by three variables.
- Sales – how many units of products will be sold at what price.
- Operating cost – how much does it cost to make those products
- Invested capital – how much capital is needed to conduct the business.
CHAPTER 5
In this chapter, a few business characteristics have been discussed in detail which will broaden our thinking and way of looking at businesses.
Business characteristics:
The great, the good, and the gruesome.
The preferences run towards businesses that generate cash, not those that consume it!
The really great business:
- High returns, sustainable competitive advantage and obstacles that make it tough for new companies to enter.
- Great business generally have moat
- Long term competitive advantage in a stable industry is what to be seeked in a business.
- If a business requires a superstar to produce great result, the business itself cannot be deemed great.
- A great business has pricing power or the power to raise the prices without losing business to a competitor
- The best protection against inflation is a great business.
An ability to increase prices without losing either of market share or unit volume
An ability to accommodate large dollar volume increase in business with only minor additional investment of capital.
The unleveraged businesses that require some net tangible asset to operate is largely affected by inflation. Businesses needing little in the way of tangible asset simply are affected the least.
Customers’ loyalty towards business creates economic goodwill. When customers are fond of your product at that time company starts earning goodwill.
The good business : earn good returns on tangible invested capital
The gruesome: require a lot of capital at a low return business
The worst kinds of business are those which grow rapidly, require significant capital to grow and then earn little or no money. Now after having insight on different characteristics and knowing the worst kind of business as well we should know that what are the characteristics of depressing industry?
Undifferentiated products
Many competitors
Easy to enter
Over capacity
What can determine level of long term profitability in such industries?
The ratio of supply-tight to supply ample years.
Its kind of impossible for commodity selling business to be a lot smarter than its substandard competitor.
Many a times in some businesses, not even brilliant management helps, this means that in any industry, situation should be good;
if any industry’s underlying economics are crumbling, then talented management won’t be able to make much difference.
If you want to get a reputation as a good businessman, be sure to get into a good business.
Every growth has its limit – no tree grows to the sky.
The correct way to look at accounting goodwill
In evaluating the underlying economics of a business unit, amortization charges should be ignored.
What a business can earn on an unleveraged net tangible asset, excluding any charges against earning of amortization of goodwill is the best guide to economic attractiveness of the operations. Goodwill should not be amortized but written off when necessary.
The key factor of success or harm and how predictable are they?
Questions one should ask themselves before predicting future of the business:
Q.1) Does the business has something people need or want now and in future that no one else has competitive advantage or can emulate the business idea and strategy and can these advantages be translated into business value?
Q.2) Can you distinguish what matters from what doesn’t?
Try to figure out key factors that make the business succeed or fail and then study them thoroughly.
CHAPTER 6
The past is useful only if it gives any clues to the future.
“IN THE BUSINESS WORLD, THE REAR VIEW MIRROR IS ALWAYS CLEARER THAN THE WINDSHIELD”.
It’s the windshield through which investor must peer and the glass is invariably fogged. Future profitability of any industry doesn’t only depend on past historic data because if it would then all the Forbes 400 would consist of librarians.
Future profitability depends on: Current competitive characteristics and not the past ones
How a business should be viewed?
ANS: Company should be looked as an unfolding movie, not as still photograph. There are high probabilities that what worked in past may not work in the future and therefore taking historic P/E or historic business valuation yardstick can go for a toss.
What can happen if any of the key assumption disappears?
There are many conditions when our made past assumptions become futile; like the situation when industry condition and technology changes, customers taste and preference changes, competition enters into the realm of toughness and chances of degradation in quality of management also arises.
Here e.g. Of a baseball manager has been given describing where he would have to judge the future prospects of a 42 year old centre fielder on basis of his lifetime batting average. Sometimes past can be very misleading.
Like The 2008 housing crisis just about when all Americans came to believe that house prices would be forever issue.
This conviction made a borrower income and cash equity seem unimportant to lenders who shelved out money, confident that HPA would cure all the problems. Salesman, rating agencies and investors made this experience a yardstick for evaluating future losses but they ignored the fact that house prices were skyrocketed, loan practices had deteriorated and houses were purchased even by those who couldn’t afford it.
In short, universe past and universe current had very significant and different characteristic.
Any good businessman or an investor should always take into consideration how well or poor their business is doing.
They should even understand that from which environment they are operating, whether business is enjoying an industry tailwind or headwind; such type of criteria should be studied.
When a business is in downturn it is the time when performance of management can be known. Whatever worked in favour management can be due to random factors. Always be careful and check whether it’s just raining or the business or management is really that good.
THERE IS ALWAYS A HIGH PROBABILITY OF MOAT GETTING VANISHED AND ALSO COMPETITORS ENVIRONMENT AND YOU SEE THE BUSINESS CONDITION CHANGING PERMANENTLY MAYBE.
Valuation must change when expectation change.
This concept is explained by giving the example of newspaper. Few years back newspapers were the only source of information but then electronic gadgets as sources popped in. Newspapers started losing the eyeballs and as our expectations from earning through newspaper changed.
Another e.g. given of Dexter shoes
The company that is managed by domestic shoe industry is generally thought to be unable to compete with import from low wage countries. The company had skilled labour force which together made the U.S plant of both companies highly competitive against all new comers. But it is true that even great businesses change over the time but not the reasons why people still buy their products or use their services.
The reason why people stick to their product no matter what changes is due to the treatment service or product they have been offered. The management should always try to reduce the cost, improve the product and service and gain the strength.
Every business should try to make its moat stronger and durable. If any company wants to have a business for a decade or two, from now they should not only focus on short term earning but also have a view on long term picture. If in case management makes bad decision in order to hit short term earnings target and forge cost, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.
CHAPTER 7
Stick to a proven management with lots of integrity and passion.
You will never succeed in making a good deal with a bad person. In any business, its culture counts more than rule books, so avoid situations where existing culture needs to be changed.
One doesn’t need to be an MBA to be talented. This sentence has been explained artistically curated and given with example of a 25 years ago a lady who came to borsheims , she was a saleswoman paid 4$ an hour . She lacked managerial background but still she was made CEO in 1994 with no hesitation. Buffett says that she’s smart; she loves the business and her associates and also added that he and Charlie are big fans of resume. Instead they focus on brains, passion, and integrity.
What management does with the cash is very important. There is seen lack of skill in CEO when it comes to capital allocation which is no small matter. After 10 years of job, a CEO whose company annually retains equal to 10% of net worth will have been responsible for the deployment of more than 60% of all capital at work in business.
There should be some quest e.g. ‘what will they do with the money’, this factor must always be evaluated along with what to do we have now; this calculation will help arriving at a sensible estimate of a company’s intrinsic value.
If a CEO can be expressed to does this well, the reinvestment prospects add to the company’s current value, if CEO’s talents or motives are suspect, then today’s value must be discounted.
Focus on three questions that are of utmost importance:
Does the company have the true CEO?
Is he/she over reaching in terms of compensation
Are proposed acquisitions more likely to create or destroy per share value?
Famous Sayings;
‘It’s difficult to teach new dogs, old tricks.’
‘Superb managers are too scarce a resource to be discarded simply because their cake gets crowded with candles.’
CHAPTER 8
Don’t readily be impressed by higher earnings.
Increase in earnings can be terrific and usually it is, but you should not readily assume that to be the case.
First make sure that earnings were not depressed in the base year.
Always ask a question, ‘how additional capital was required to produce the additional earning?’
If return on capital is ordinary and if you are required to put more money to earn returns then it is no great managerial experience.
When things don’t work as they were supposed to, some change the yardstick.
When results deteriorate, most managers favour disposition of yardstick rather than increasing their (manager) efficiency.
Be wary of those business managements who explain away bad results by using “except for and highlight only the good results. By using except for and stating that they learnt lesson from their mistake, are usually missing the only important lesson namely real mistake is not the act, but the actor.
CHAPTER 9
The boards most important job is to pick the right person to run the business and evaluate their performance.
This means that directors must get rid of a manager who is mediocre or worse. Selecting a right director is very important; too often directors are selected simply because they are prominent or add diversity to the board. Furthermore mistakes in selecting directors are particularly serious because appointments are hard to undo.
Whenever you select a director, don’t select him/her on basis of his/her grade, appearance etc.
Any director that is to be selected should be asked few simple questions.
Does the director faithfully represent owner?
Or any director that is to be appointed should be questioned “does he think like an intelligent owner?”
If you are selecting a candidate for football team, cricket or an arbitration panel etc. then in those cases selectors would look for people who have specialized talents and attitudes.
TRUE-INDEPENDENCE
True independence means when director is ready to challenge an adamant CEO when something is wrong or foolish. It is an enormously valuable trait in director.
Directors that are to be selected should have huge and true ownership interest (e.g. that is stock that they or their family have purchased). Directors should have a major portion of their net worth invested in the company---- we eat our own cooking.
Bottom line for directors: You win, they win big; you lose, they lose big.
CHAPTER 10
Marriage between owners and managers, there should be a good sync between individuals knowing common goals and a shared destiny to make a happy business. Our trust is in people rather than in process.
Just follow the golden rules:
Every owner should treat their mangers in a manner that they would wish to be treated if their position were reversed. Managers are happiest when they are left alone to run their business and that is customarily just how we leave them.
Managers are totally in charge of their personal schedules. Second we give each a simple mission.
Just run your business as if you own 100% of it.
It is the only asset you and your family has or will have.
You can’t sell or merge it for at-least a century.
Famous Sayings:
Owners to managers: Just tell us the bad news; the good news will take care of itself. (The behaviour that is expected from managers when they are reporting)
In any business, managers are supposed to think not about what counts, rather how it will be counted.
CHAPTER 11
Management and owners should have the same interest. Work with people who make money with owners and not out of them. Management should have no interest in large salaries or options or other means of gaining an edge over the owners. The people who make the decision should be accountable for the consequences and face both the down side as well as the upside.
Make sure incentives are tied to the same variable of float growth and cost of float the same variable that determines value for owners.
Incentive should be tied to the result of the area the manager is responsible for, and can impact. Incentive should be tied to operating result for which a CEO has been given authority.
The rewards can be large in setting compensation, owner should hold out the promise of large carrots but make sure the delivery is tied directly to result area that a manager controls.
Owner’s should not put a cap on bonuses and the potential for reward is not hierarchical. Managers of small unit can earn far more than the manager of larger unit if results indicate that he should.
There are many good ways to structure a good incentive system.
Performance: It is defined in different ways depending upon the underlying economics of the business. In some managers enjoy tailwinds not of their own making; in others they fight unavoidable headwinds.
At Berkshire when capital invested in an operation which is significant they then also charge managers high rate of incremental capital they employed and credit them equally at high rate for capital they release.
When earnings increases on capital employed by manager, that time his bonus also increases. Options can be appropriate under some circumstances if they are structured right.
Options should be avoided only to those managers with overall responsibility.
Managers with limited area of responsibility should have incentives that pay off in relation to results under their control.
Options should be priced at true business value.
CHAPTER 12
Dumb acquisition cost owners far more than most other things.
Types of companies that one should look into:
- Business we understand
- Favourable long term business
- Able and trustworthy management
- Berkshires acquisition criteria:
- Large purchases
- Demonstrated consistent earning power
- Business earning good return on equity while employing little or no debt
- Management in place
- Simple business
- An offering price
Always ask one question before M&A, ’what is the best use of my cash?’
‘Do I want to invest my cash into this business at this price today or there is something else I would rather do with my cash?’
Berkshire doesn’t have any strategies or insights at the time of acquisition.
Acquisitions are only made if they increase the value. Rather while considering acquisition, we attempt to evaluate the economic characteristic of the business. Its competitive strengths and weakness and the quality of the people we will be joining. Don’t believe you know more about the value of business than the seller.
Why do they sell? Do they love the business more than money?
It is meaningful when an owner cares about whom he is selling his business to. Its likely to do business with someone who loves his company not just the money that a sale will bring him.
When some emotional attachment exists, it signals that important qualities will likely be found within the business. Reverse is also true.
CHAPTER 13
Be honest and trustworthy and select people you can trust. Don’t hire and work with people who have to be reminded to be honest, nice and trust worthy.
Protect the reputation! Losing money is affordable rather loosing reputation.
When in doubt, remember Warren Buffet’s thumb rule: I want employees to ask themselves whether they are willing to have any contemplated act appear next day in newspaper that is spouse and children and friends read.
Don’t get fascinated by good appearance of annual report what needs to be reported is data like;
Approximate company’s worth.
What is likelihood that it can meet its future obligation.
How good a job is, its managers doing given the hand they have been dealt?
Accounting numbers are the language of business and as such are of enormous help to anyone evaluating the worth of business and tracking its progress.
CHAPTER 14
When investing pessimism is friend, euphoria the enemy.
Avoid business whose futures we can’t be evaluated no matter how exciting their products may be. It is important to be in business where tailwinds prevail rather than headwinds.
An investor needs to do very few things right as long as he or she avoids the mistakes. Predicting the long-term economics of companies that operate in fast changing industries is simply far beyond our perimeter. ---- we just stick with what we understand.
If something is not worth doing at all, its not worth doing well.
Try to be fearful when others are greedy and try to be greedy when others are fearful.
Minimize the chance that I make a bad deal , know where I have an edge and buy with margin of safety. Stick to what you understand and where you have talent and forget about the things you don’t.
Always ask few questions:
Do I really understand the company product?
Nature of its competition?
What can go wrong over the time?
Fear is the foe of the faddist but the friend of the fundamentalist. Investor should remember that, excitement and expenses are their enemies. Big opportunity comes infrequently; when it is raining gold, reach with a bucket not with tumbler.
Predicting rain doesn’t count, building arks does.
How can you lose here? How hurt you can be? First focus on what you can lose before looking at what you can make and if you can’t judge what can go wrong, stay away! Borrowers who shouldn’t have borrowed were being financed by lenders who shouldn’t have lent.
CHAPTER 15
Whenever any mistake is made, always admit it “I was wrong and change course, its never a good idea to catch get events --- I don’t have to make it back the way I lost it. Do post-mortems of your own dumb decision and try to avoid the same circumstances again in future.
Learning from your own mistake is good but it is better to learn from others mistakes. Prevention is always better than cure. Adapt and change your views when the facts and circumstances change.
And the most important always think like a businessman. “Investment is most intelligent when it is most business-like.”
In all events, success depends on previous preparations, and without such previous preparation there is sure to be failure. -Confucius
My key take-away from the book:
This book mainly targets the significance of having a good management as management are the only personnel who are running the show. There is an important point discussed, that historic results can not be the only source for having a future benchmark that means just by considering past data it is not possible for individual to estimate the growth for future.
Merger and acquisition plays an important role, any M&A done should raise the value of the company. For any investor what should matter the most is, accounting numbers and not the appearance or fancy details in the annual report.
If any management gives absolute number, stay cautious because that management can do any shenanigans to reach those numbers. Intrinsic value is more important than book value because when you consider intrinsic value you discount the cash flow with all the uncertainties that is expected to arrive in future.
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