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The Essays of Warren Buffett

I have recently read the The Essays of Warren Buffett, which is a collection of his letters to Berkshire Hathaway's shareholders.  The book is arranged in a way so that the letters are not in chronological order, rather they are organized by topic.  For example: If the subject is corporate governance than the letters that pertain to the topic are categorized under that heading.

Before I go further, let me preface this by saying there is so much information in this book that in order to really appreciate everything you should have a basic understanding of finance and accounting, and that my post here will not cover all the topics spoken about in the text, but will only be siphoned down to the key components that I think are important to know.  In short, I recommend reading this book to get the full experience of what Mr. Buffett has to offer.  The Essays not only offers lessons about corporate America, but also teaches us lessons that are applicable to everyday life.

For those who do not know, Warren Buffett is the CEO of Berkshire Hathaway.  Berkshire is a holding company that owns companies such as GEICO and Fruit of the Loom, and holds large stakes in others such as American Express and Coca-Cola.

For the average person who seeks to learn about the stock market or is trying to understand how Mr. Buffett sees the market, this book offers a good lesson into that.

This first item that jumps out to me is that Mr. Buffett speaks to the notion of not diversifying your portfolio.  The reason being is that if you think that you have found a company that is financial sound, run by competent and admirable managers, and has strong earning potentials, then you should invest your money into that company.  This philosophy is predicated on the belief that it is easier and more realistic to find and research 5 solid companies worth investing in, than to find 10 - 15 companies that meet the same standard.

Another reason why he promotes investing in fewer companies is because it is better to hold a larger percentage in a solid company, instead of equally distributing your resources across good, mediocre, and bad companies. Also, it is much easier to manage and supervise a smaller portfolio.  Through this you can develop an intimate understanding of what the companies are doing and what direction they are heading in, and thus what decisions you will ultimately make.

The second item is to shift your mindset from an investor to that of an owner.  If you are looking to invest in a company you should be asking yourself questions as if you were an owner of that company.  And, in essence as a shareholder, you are an owner of the company.  Mr. Buffett impresses on the reader the importance of having people you admire running your companies.  However, this is a very subjective criteria; since what people deem as admirable varies from person to person.  Nonetheless, it is important to do research on who the CEO is of the company that you are looking to invest in.  What is his/her version for the company?  What are their beliefs?  Educational/Work background?  And ultimately, are their strategies and vision for the company fundamentally sound?

The other thing as an owner to consider is to determine how the company will use its earnings and profits.  Berkshire is known for not paying out any dividends.  They often use that money to buy back more of their stock (which increases your holdings in the company, for example: if you own 1 share of Berkshire class A and there are 100 shares outstanding, and Berkshire buys back 1 share using that money instead of paying dividends.  You went from owning 1/100 of the company to 1/99 of the company), reinvest in the company (For example: machinery to improve production), or acquisitions (For example: purchasing more shares of American Express or procuring full ownership of a company such as GEICO).  All these things are strategies that can be used to improve the financial standing of the company, which as an owner is important to you.  However, investors may only want to see an immediate return and cash in hand, such as cash through dividends.  And, while Berkshire benefits from dividends from other companies, it does not give out dividends to its shareholders, for the purpose of improving the company.  Ultimately, as an investor you will have to make that determination of what you value more, and what meets your financial goals.  I would like to share that while the book was being written, Berkshire Class A was priced around $10,000 per share and that seemed to be around the 1990's.  As of today May 21, 2017 it is priced at $244,910 per share.

That leads us into the third point which is value and consistency. You want to find a company that is doing something of value.  For example: which do you find to be more valuable as whole?  Coca-Cola or Snapchat?  I would like to think most of us would say Coca-Cola as it offers an actual beverage that you can consume (albeit very sugary ones) as to pictures with modified filters.  This is a simplified version of finding value in a company (I'm not speaking of a value company which is something a bit different).  It is important to identify value in a company because that is ultimately why people put money into it.  People will buy Coca-Cola because they like the taste or find it refreshing.  People may not buy Snapchat, if you had to pay for the application.  The thing to note is that they both face incredibly stiff competition, and Coke has been the king of the soft drink market for as long as I have been alive.  Snapchat, was the first to create a somewhat augmented reality photo filter and it is not the most popular application of its kind.  With Instagram now offering the same filters, on a more widely used application, it is hard to see how Snapchat can find a way to be profitable.  Ultimately, this circles back to leadership, and finding admirable managers.  Read up on the CEO of Snapchat, Evan Spiegel.  While clearly an intelligent and wealthy man, he is certainly not admirable in my opinion.

When speaking of consistency, we are really speaking of long term investing.  Berkshire has conducted itself to provide minimal transactions in the market, especially in their Class A stocks.  This in turn speaks to the kind of investor the company is looking for, someone who wants to be a part of the company, and feels comfortable leaving their money in the company's hands and who in turn will garner them a return for their faith.  In short, place your money into companies that you will invest in for the long haul.

So I mentioned a lot of mindset points here and less about analyzing companies.  Mr. Buffett speaks to some degree about book value, price to earning ratios, and beta analysis.  While they are all important when making a decision they can also be deceiving.  A lot of these metrics are predicated on past performance and may not always dictate the future.  For example: The Yankees can be playing the Red Sox at Fenway, and be up 7 to 4 in the bottom of the ninth.  While it seems likely they'll win the game, there is also the chance they can lose, and in fact that has happened more than once to a multiple of teams.

If you use book value to help determine the value of a company, it is recommended to remove the intangible assets from your calculation.  This in turn will lower the overall value of total assets, and it is a more conservative approach to finding the book value.  Mr. Buffett recommends approaching most things with caution as it is better to be sure, than to speculate.  He often makes the point that if you do not know how to invest, then don't invest, place your money in an index fund.  They'll beat out most active managers anyways.  But if you do choose to invest then always be sure.  It is always better to be prudent and sure than to speculate value.  It's like the old saying, one bird in the hand is worth two in the bush.

Book value essentially is [Total Assets - (Intangible Assets + Goodwill)] - Total Liabilities

Typically people like to use the value above and find the price to book ratio which is just
the Book value/Shares outstanding.

**On a side note, you can find this information available on several of websites that track this information, however, they tend to just do shareholder equity/shares outstanding.

So as I mentioned above there are several of metrics that you could use to evaluate a company and an example of one is listed above.  Mr. Buffett stresses the usage of all these metrics, including the information from generally accepted accounting principles.  While all these things are useful they are not the end all be all.  When it comes to values (as in numbers), he stresses the importance of intrinsic value.  To simplify intrinsic value, it is looking at a company in a holistic point of view.  The qualitative aspects, such as how it is run, who runs it, and their plan for the future.  As well as their quantitative data such as their balance sheet.  He doesn't go into much detail about how to tabulate a company's intrinsic value, but rather he speaks of the importance of it, and using it to determine the company's future earnings.  Which is ultimately what you want to try to predict.

This book contains so many aspects of what determines a good company, and all the items to consider when evaluating a company.  He speaks to things from goodwill, taxes, replacing machinery, accounting principles, corporate governance, acquisitions and mergers, and the list goes on.  But ultimately what he speaks about (in my opinion) is that in order to invest successful, narrow your focus, do your research (qualitatively and quantitatively), and buy when the price is appropriate.

I'd like to close this out by sharing that Mr. Buffett mentions Benjamin Graham a great deal, who was his former professor, and who is also viewed as the father of value investing.  If this post sounded interesting to you, I recommend reading the Essays on Warren Buffett and then the Intelligent Investor by Mr. Graham.  If you have any thoughts or comments we'd love to hear from you.


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