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In his book The Warren Buffett Way, These are as follows: 1. Business Tenets a. Is the business simple and understandable? 2. Management Tenets a. Is the management rational? 3. Financial Tenets a. What is the return on equity? 4. Value Tenets a. What is the value of the company? 1. Business Tenets There are three main questions every investor must ask and reflect on under this set of principles, which deals with how a business operates. These are: a. Is the business simple and understandable? a. Is the business simple and understandable? You must have a very good understanding of how the company you want to invest in operates. In this respect, you must not only have an understanding of the products or services it offers, you must also understand the industry sector to which it belongs. In addition to this, you must have a good grasp of: • the revenues the company brings in b. Does the business have a consistent operating history? It is important to invest in companies that have a consistent track record of producing good products and services and earning good returns over a period of several years. c. Does the business have favorable long-term prospects? It is important to examine the long-term competitive advantage of a company and determine whether it is enduring. In other words, you must invest in companies that have the following characteristics: i. products or services that are needed or desired These are the characteristics that give a company its competitive advantage. These are the characteristics, which contribute toward making a company great. In this regard, Buffet defines a great company as one that will remain great for 25 to 30 years. 2. Management Tenets There are three main questions every investor must ask and reflect on under this set of principles, which deals with the quality of the management the company has in place. These are: a. Is the management rational? a. Is the management rational? The most important duty of management is how it allocates the company’s capital. This is most important because it is the manner in which capital is allocated that determines shareholder value. Allocating the company’s capital—in other words deciding what to do with its earnings is according to Buffet an exercise in logic and rationality. The logic and rationality that managers display becomes most important when a company has attained maturity to a certain level. At this point in its growth cycle, the company is growing more slowly and generating more income than it requires for its operating costs and further development. So, in the above-mentioned scenario, how should management allocate the company’s earnings? There are two pathways in this regard. • If the revenue generated can produce a return that that is higher than the cost of capital, then the company should retain and reinvest all of its revenue. To do otherwise would be deemed irrational. • If the revenue generated by the company produces returns that are average or below-average, it has three options. It can continue to reinvest those earnings at rates of return below the average, it can buy growth by acquiring other companies, and it can return the money to the stockholders in the form of dividends. The choices management makes will determine the quality of their rationality and logic. b. Is the management candid with the shareholders? Managers should be candid with the shareholders. They must be willing to admit their mistakes as well as share their successes. They must be willing to inform their shareholders of the company’s performance with clarity and without using Generally Accepted Accounting Principles (GAAP). c. Does the management resist the institutional imperative? Institutional imperative characterizes the tendency of corporate managers to act in a leminlike way and become imitators of other managers, regardless of how immature they are. Adherence to the institutional imperative can lead to: • the company resisting any change in the way it operates 3. Financial Tenets There are four main questions every investor must ask and reflect on under this set of principles, which deals with the financial performance of the company. These are: a. What is the return on equity? a. What is the return on equity? It is important to determine whether a company achieves a high rate of return on its equity capital and not whether the returns in earnings per share it achieves are consistent. b. What are the company’s owner earnings? It is important to note that the accounting earnings per share should be used as the starting point for calculating the economic value of a company. The accounting earnings per share should not be seen as the end point. In addition, investors must be cautious when using cash flow to calculate the value of a company. The reason for this is that the “cash flow” figure when it is normally used, excludes the capital expenditures that the company will need to spend on new equipment, machine upgrades, etc. to maintain its economic output. Instead, it is best to use “owner earnings” which is calculated as a company’s net income plus depreciation, depletion, and amortization, minus the amount of capital expenditures and any additional working capital that may be required. c. What are the profit margins? A great business can be regarded as a poor investment if the management is unable to convert sales into profits. You should try to determine whether the management of a company has a reputation for running low-cost operations or high-cost operations. In this regard, you should try to determine whether a company has the appropriate number of staff and whether its budget contains unnecessary expenses. d. Has the company created at least one dollar of market value for every dollar retained? You must determine whether the company you are investing in creates one dollar in market value for each dollar of retained earnings. The reason for determining this is because it will help you quickly spot companies where the management has been able to successfully invest the capital in the most optimal way. 4. Value Tenets At the Berkshire Hathaway annual meeting in 2003, Warren Buffet made the following statement: “It’s bad to go to bed at night thinking about the price of a stock. We think about the value of a company’s results; the stock market is there to serve you, not to instruct you.” Investors must periodically re-examine the company’s value to see how it relates to the market price. Based on this, the investor can make rational decisions regarding whether he or she should buy, sell, or hold the stock. There are two questions one must ask when making these kinds of rational decisions. These are: a. What is the value of the company? a. What is the value of the company? Warren Buffet regards the use of the Dividend Discount Model to determine the intrinsic value of a company. The theory underlying the Dividend Discount Model was created by John Burr Williams and presented in his book The Theory of Investment Value. Determining the value of a company using this model involves two steps: i. First it involves calculating the total of net cash flows (owner earnings) that are expected to occur throughout the life of the company. To estimate a company’s future earnings, you would need to incorporate all the research you have done on the characteristics of the company, its financials, and the quality of its management. Warren Buffet’s yardstick in this regard is predictability. He invests in companies whose future earnings are as predictable as the income you would derive from investing in bonds. And a key part of his strategy involves only investing in companies that he understands. ii. Second, it involves discounting those net cash flows by an appropriate interest rate. In order to discount the net cash flows of a company by an appropriate interest rate, you first have to determine what the appropriate discount rate should be. This according to Buffet is the rate that would be considered to be free of risk. For many of the investment decisions he made, Buffet used the current interest rate for long-term government bonds. This is because of the 100 percent certainty he felt that the U.S. government would pay its coupon (interest rate returns) on these bonds over the next 30 years. So in these circumstances, when interest rates are at a low level, Warren Buffet raises the discount rate he uses. When the interest rates are high, he matches his discount rate to the longer-term rate. If the interest rates do not rise, he increases his margin of safety. b. Can it be purchased at a significant discount to its value? Conclusion In sum, you must invest in companies that are run by an honest and competent management team and that are selling at prices below their intrinsic value. Table of Contents Comments are closed. |
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Robert G. Hagstrom organizes the principles that generally govern Warren Buffet’s investment strategies into four categories. 
