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'Buffett-ites or Bluff-it-ites?'
Buffett | 5 Comments | Mon 03 Jan 2011
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Someway through his investment career Warren Buffett broke from the ‘restrictive' Ben Graham value investing mould. Buffett is prepared to pay up for businesses that he believes have barriers to entry, or ‘moats'. These are business that can sustainably earn high returns on investment, which in time more than justifies their initial premium rating. But beware: Buffett's approach requires great insight and analysis. The penalty for mis-diagnosing a moat is a sharp share price fall.



Comments

1.
On 09/02/2011 23:49:00, Anonymous wrote:
This article really captures the difference between Buffett and Graham... but maybe you are a tad harsh on IBM?

2.
On 11/02/2011 15:21:15, VII wrote:
Yes, perhaps a tad harsh. And Lord knows I'm no expert on IBM. The point I was trying to make was that IBM was once dominant in mainframe computers, missed the rise and dominance of the personal computer, and eventually was lucky enough to survive and reinvent itself as an IT service company. Their once dominant fortress crumbled in a surprisingly short period of time (and Big Blue was forced to make a living elsewhere). I'm sure that blindsided many investors at the time.

3.
On 14/02/2011 13:34:13, Anonymous wrote:
technology and innovation change in ways similiar to evolution called punctuated equillibrium. Many economic niches or moat related margin advantages are stable and decay rapidly due to the negative optionality of external innovation.

I am writing a capital allocation book on the topic. As a hedgie PM, I use these mental models fairly effectively.

4.
On 16/03/2011 10:24:18, Colin Farrier wrote:
Stirring stuff.

Let me start with your second paragraph"Economic moats" and food retailing. I accept that Walmart has dominated the USA in food and other commodity retail, however, the operating margin is 7.5% showing huge competition and not able to 'sustain high margins'.
In your next paragraph you refer to the Graham mechanical method, but I would point out that in his book Intelligent Investor (first edition) he describes a valuation process that could be the lost transitional phase for Buffett's consumer monopoly methods. I have pasted here my personal note about this:
Capitalisation Multiplier Method of stock valuation

A Introduction

Ben Graham has proposed a method of determining an intrinsic value starting with an average projected earnings figure that is grossed up by a multiplier.

B Key Aspects

1. Historic Earnings. The 1949 classic text of ‘Intelligent Investor’ focuses upon the impact of the 1939 – 45 war upon earnings and the expected reversion to norm.
2. General Long Term Prospects. The classic text of ‘Intelligent Investor’ proposed certain sectors were seen as having an endemic 'quality'.
3. Management. Ben Graham has no tools with which to assess the quality of management other than the accounting data.
4. Financial Strength and Capital Structure. While Graham in 'Intelligent Investor' accepts a modest amount of bonds and preferred stock in a company's finance structure he does not provide any guidance to an acceptable quantum.
5. Dividend Record. The classic text of ‘Intelligent Investor' proposes that a track record of uninterrupted dividends to 1949 including the period 1931 – 33 would merit a favourable treatment in the valuation process.
6. Current Dividend Rate. Graham has said that in 1949 the ‘standard dividend policy' was to was to pay out two thirds of average earnings.
7. Asset Value in Valuation Method. Graham points out that in 1949 the value of a company is determined by analysis of expected earnings, general prospects and the tenure and rate of dividends, and that no influence of book value was required.

C Capitalisation Rate

Graham refers to a capitalisation rate or multiplier that should be adopted to convert the earnings per share to an intrinsic value. He refers to 10 for companies with certain levels of debt and /or preferred stock. A multiplier of 20 is inferred as appropriate for top quality stocks.

D Margin of Safety

On p161 the author also recommends the purchase of the stock only if the capitalisation (intrinsic value) exceeds the market price by at least a third.

E Summary and Conclusion

The 1949 text of ‘Intelligent Investor’ provides a framework for the analysis of a stock by historical earnings information, sector and dividend and proposes a variable multiplier method for estimating the intrinsic value. I suspect that this was the corollary to the earlier book ‘Security Analysis’ in which the methods for analysis were discussed. This seems to deny the exclusive ‘Graham cigar butt’ investment process.
In your para 6 'Jean-Marie Eveillard' you refer to the 'qualitative side to the Buffett approach' and I agree that this is the main area with which I struggle. This includes the appraisal of the company management performance and attitude. I have so far only identified limited indicators such as the adoption of ROE as a KPI and the ratio of the remuneration of the top paid directors to the total salary bill. The book 'The Strategy Paradox' by Michael Raynor also helped me to understand strategy from an investor's perspective.
In your para 9 'Other value stocks' you refer to software able to screen for value stocks using the current accounting year (I call this the vertical slice) but I use REFS to source accounting data to populate a spreadsheet for a ten year window (I call this the horizontal slice). For many elements a cumulative average over the period allows comparison between stocks. I admit this is a slow, mechanical method and would only be used on the remaining contenders on a very shortlist. I recently read the book 'Rule No 1' by Phil Town and there are many similarities in my philosophy with his, apart from the sell indicator systems.
Finally in your para 10 'For me,' you refer to Buffett's complex investment approach. I think that Buffett has moved from the valuation by multiple of Graham that I described above to consumer monopolies with considerable competitive advantage and then to cash-rich stocks (reducing the risk from gearing). He also is further up the ladder of qualitative analysis and management appraisal.

5.
On 23/03/2011 10:24:05, VII wrote:
Colin, thanks for your comments.


If I could summarise the central point of your post, Graham wasn’t just a net-nets investor. I fully accept that (and you clearly have done a lot of work to back this up). The point I was making was that Graham placed much less emphasis on qualitative aspects of businesses than Buffett, who added this skill to his investment weaponry over the course of his career. This is a very difficult skill to master and should not be underestimated by even very experienced (value) investors.

I’m not sure how you are conducting your screen but I’m familiar with Bloomberg data and it really is fantastic these days. It is able to screen stocks using many years of data over a wide range of metrics. Of course, if this data is easy to get then I'm hardly the only one looking at it. There's hope though - for example witnesses to a car crash will often give very different versions of 'the facts'. Similarly in markets – stocks that screen 'cheap valuations' are typically dismissed by investors with short time frames because, say, the outlook for current year profits is poor. It is here the patient value investor can still take advantage, I believe.

Just to pick you up on your Walmart comment, I wouldn’t focus on the company’s margins so much (though they are good vis a vis their peers), as that tells you nothing about the amount of capital required to achieve those margins. A much better gauge of profitability is return on equity, which for Walmart has been a none-to-shabby 20% over the last 20 years (pretty consistent too). I think this is indicative of the economies of scale moat that I referred to in the article. And don’t think I’m defending Walmart – I’ve zero financial interest in the company and I don’t even know the industry that well, I would just suspect that their massive size makes them a fierce competitor.

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