The Formula for Valuing All Assets

“Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.” 

―Warren Buffett

How to Value a Business

Excerpt below from Warren Buffett’s 2000 letter to shareholders. Emphasis added. 

Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush  and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota  nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, 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 will generate in later years. Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component  usually a plus, sometimes a minus  in the value equation.

Alas, though Aesop’s proposition and the third variable  that is, interest rates  are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

 Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT  Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation – in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it  is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities  that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future  will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

Last year, we commented on the exuberance  and, yes, it was irrational  that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return.

Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.

This surreal scene was accompanied by much loose talk about “value creation.” We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.

What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.

But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street  a community in which quality control is not prized  will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”). Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.

Lately, the most promising “bushes” have been negotiated transactions for entire businesses, and that pleases us. You should clearly understand, however, that these acquisitions will at best provide us only reasonable returns. Really juicy results from negotiated deals can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic. We are 180 degrees from that point.

Source: Warren Buffett’s Berkshire Hathaway Letter to Shareholders, 2000

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Content in the table below is based on Warren Buffett’s discussion – in his letter to shareholders in 2000 – on how to value an asset.sl2000valuinganasset

Business Quality: The Great, the Good, and the Gruesome

“A moat that must be continuously rebuilt will eventually be no moat at all.” 

―Warren Buffett

Excerpt below from Warren Buffett’s 2007 letter to shareholders. Emphasis added. 

Businesses – The Great, the Good and the Gruesome

Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Source: Warren Buffett’s Berkshire Hathaway Letter to Shareholders, 2007

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Content in table above based to a large degree on SafalNiveshak’s article Wit, Wisdom, Warren (Issue #10): Businesses – The Good and Gruesome 

Notes & Quotes – The David Rubenstein Show: Warren Buffett

“Investing is just about assigning yourself the right story.”

—Warren Buffett

David Rubenstein Talks to Warren Buffett

When I got home from work today I found this new episode of the David Rubenstein Show available, this time a talk between David Rubenstein and Warren Buffett.

The interview is about 25 minutes and I spent the time on my back in my bad watching and listening, just having a good time. A spoiler here… There was no talking about Wells Fargo. The subject wasn’t even brought up. I don’t know at what date the interview was recorded, but it’s not unreasonable to believe that the interview was taped before the Wells-Fargo scandal hit the headlines.

Topics discussed range from pinball machines, Harvard Business School, Benjamin Graham, Columbia Business School, Washington Post, Bill Gates, smartphones, computers, and philanthropy, bridge, search among others.

When watching and listening to an interview that I find especially interesting, I’d like to put down in writing the things I enjoyed the most. I do this to share with the readers of this blog, but also to archive it in a place I know I can go back to later on. 

Below you’ll find the parts transcribed by me. Hope you enjoy it.

The Best Business: The Pinball Machine [01:59-02:39]

David Rubenstein: You grew up in Omaha, but then you moved to Washington when your father became a congress man. How did you start you business career in Washington, with various pinball machines or golf businesses?

Warren Buffett: Yeah, I was like that with a couple of businesses going. The best business we had was the pinball machine business, which was the Wilson Coin and operated a machine company, and it was named after the high school me and my partner went to. But, we had our machines in barber shops, and the barbers always wanted to put in the machines with flippers which were just coming in. But those machines cost 350 bucks, whereas an old obsolete machines cost 20 bucks. So, we always told them we’d take it up with Mr. Wilson, this mystical Mr. Wilson. He was one tough guy, I gotta tell you.

Going to College as a Way to Please Dad [02:40-03:05]

David Rubenstein: So, when you graduated from high school you weren’t as interested in the academics, I assume, at that time?

Warren Buffett: I was not interested.

David Rubenstein: And your high school yearbook said he’s likely to be a stock-broker, but he’s very good in math. Why didn’t you go to Wharton? And why didn’t you wanna stay two years there?

Warren Buffett: I didn’t wanna go to college, and… But my dad wanted me to go to college. And we didn’t have SATs then, but he practically would have done the SATs for me. So he… and the truth… I always wanted to please my dad. He was a hero to me and still is.

Working for Benjamin Graham: The Hero [04:55-05:40]

David Rubenstein: You worked for Mr. Graham and his partnership, and how did that work?

Warren Buffett: Well, it was terrific in the sense a was working for my hero. But Ben was going to retire in a couple of years. And, so I was only back there a year and a half. But, every day I was excited about being able to work for him.

David Rubenstein: So, what you were good at where picking stocks according to his formula, which is to look for stocks that were undervalued, now call value investing. Did you realise that he had some principles that were very unique, and is that why you followed his guidance?

Warren Buffett: Well, by the time I went to work for him I probably could have recited the words in his book better than he could. I’d read his books multiple times, and so it was more a question of being inspired by him than it was learning something new from him.

The Reason For the Success [08:12-08:42]

David Rubenstein: What would you say is the reason for your ability to do this? Is it that you study the companies more than anybody else? You’ve stuck to your principles? You were smarter than other people? Or people were just caught up with fads, and you didn’t get caught up with fads? What would you say is the reason for the success?

Warren Buffett: Well, the first two to quite an extent. We bought businesses that we thought were decent businesses at sensible prices and we had good people to run them. But we also bought marketable securities in Berkshire. Over time the emphasis shifted from marketable securities over to buying businesses.

The Railroad [08:42–08:52]

David Rubenstein: What was the theory behind buying a railroad? Cause people thought they were kind of fossils, these businesses.

Warren Buffett: The railroad business had a bad century, the kind of like Chicago Cubs. Everybody has a bad century now and then.

The Washington Post: A Bargain Price [09:01–11:29]

David Rubenstein: Over the years you’ve bought a number of companies and had stakes in companies, one of the ones I know very well is Washington Post. How did that come about?

Warren Buffett: Well, in 1973… the Washington Post Company had gone public in 1971, right about the Pentagon Papers time. But in ’73 the Nixon administration was through Bebe Rebozo who was a pale of Nixon, they were challenging the licenses of two of the four television stations the Post owned. So the stock went from 47 down to 16. Now at 16 there were about five million shares outstanding. So the whole Washington Post company was selling for 80 million dollars, and that included the newspaper, four big TV stations, Newsweek, and some other assets, and no debt to speak of. So, the Washington Post Company which was intrinsically worth four or five hundred million dollars was selling for about eighty million in the market. We bought most of our stock at an equivalent of 100 million in the market. And it was ridiculous, I mean, you had a business that unquestionable worth four or five times what it was selling for. And Nixon wasn’t going to put them out of business.

David Rubenstein: When you’re doing these analyses, then and now. Do you have computers that help you? How do you actually read all materials? And how did you in those days get the materials to read about the Washington Post? How do you do it today?

Warren Buffett: Well, I… pretty much the same way except there’s a few more opportunities now. But I met Bob Woodward back, and he’d just come up with all the presidents men, and all of a sudden at thirty years of age he was becoming quite wealthy, and we had breakfast or lunch over at the Madison Hotel. And he’d say: “What do I do with all this money?” And I said: “Investing is just about assigning yourself the right story.” I said imagine Ben Bradley this morning said to you: “What is this Washington Post Company worth?” What would you do? You’d have to write the story in a month. You’d go out and interview TV and brokers and newspaper brokers, and owners and just try to value each asset. I’d said: “That’s what I do. I’d assign myself the right story.” And it’s nothing more than that. Some stories I can’t write. If you ask me to write a story on whether some glamorous but non-profit business is worth, I don’t know how to write that story. But if you had asked me to write this story about Potoma Electric Power or something like that, I can write a story. And that’s what I’m doing every day. I’m assigning myself a story and then I go out and…

David Rubenstein: So you get the annual reports, and you read them. Just like other people read novels, you read annual reports?

Warren Buffett: That’s right.

David Rubenstein: And then, do you do the calculations in… what things are worth, in your head?

Warren Buffett: Sure.

Computers, Bridge and Search [11:30–11:42]

David Rubenstein: Do you use a computers to help you?

Warren Buffett: No. If you need to carry something out to four decimal places, forget it.

David Rubenstein: Today, do you use a computer today, even?

Warren Buffett: I use it to play bridge, and I use it to go to search… a lot.

The Highlight of Deals [15:25–16:31]

David Rubenstein: What would you say are some of the highlights, the deals that you’re most proud of? Let’s take one that you did recently. The biggest deal you’ve ever done was Precision Castparts, about 47 billion dollars.

Warren Buffett: Yeah, it was between 42 and 43 billion of cash, and then we assumed about four billion of debt.

David Rubenstein: Okay, so how much… for to spend 47 billion, you spent a year studying the company?

Warren Buffett: No.

David Rubenstein: How much time did you spend with the CEO?

Warren Buffett: I met the CEO, I think on July 1, last year. And he happened to be calling on certain shareholders, and one of the fellows in our office had had a position for some time. It was an accident I met him. If I’d been out playing golf or something it never would have happened. When then I liked him. I heard him talk for thirty minutes I then said to the fellow in our office: “Call him tomorrow and say if he would like to receive a cash bid from Berkshire Hathaway. We would supply one, and if he didn’t like to receive one; forget we ever called.”

David Rubenstein: That was it? Did you hire any investment bankers to help with the analysis?

Warren Buffett: No. No.

David Rubenstein: Do you ever hire any investment bankers to help analyse a company?

Warren Buffett: No. Not to help analyse a company.

Acquisitions and Mental Filters [17:41–18:05]

David Rubenstein: Now, people must call you every day and say: “I have a deal for you. It’s perfect.” And how often do any of these deals pan out?

Warren Buffett: They don’t call every day, and we’ve made our criteria fairly clear. So there’s relatively few that call. And when somebody calls I can usually tell within two or three minutes whether a deal is likely to happen or not. There’s just some half a dozen filters, and it either makes it through the filters, or it doesn’t.

Click here to see the whole interview.

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Bill Gates on Warren, Bridge, Business Analysis and Tennis

“He was the first person to really ask me about software, and software pricing, and why wasn’t IBM with all of their strength able to overwhelm Microsoft. What was gonna happen in terms of how software would change the world?”

—Bill Gates

David Rubenstein Talks to Bill Gates

This morning I found out about a brand new interview series available via Bloomberg called the David Rubenstein Show. The first episode was broadcast on October 17, 2016, and contains and interview with Bill Gates.

Over at the Bloomberg site the show is described in the following way.

“The David Rubenstein Show: Peer-to-Peer Conversations” explores successful leadership through the personal and professional choices of the most influential people in business. Renowned financier and philanthropist David Rubenstein travels the country talking to leaders to uncover their stories and their path to success. The first episode features Microsoft co-founder Bill Gates. (Source: Bloomberg)

The interview is about 25 minutes and is time well spent. To be honest, there’s not much of news here. But, listening to Bill is usually very interesting. Topics discussed range from Microsoft, Harvard, bridge, Warren Buffett, and philanthropy, among others.

I have transcribed the part of the interview where Bill talks about his relationship and friendship with Warren Buffett. This part starts at about fifteen into the interview and goes on for about 3-4 minutes.

DAVID ROSENSTEIN: When your mother first said: “I’d like you to come and have dinner with me, and Warren Buffett will be here. You should meet him.” You didn’t seem that interested. Why was that?

BILL GATES: Warren, I though was somebody who bought and sold securities which is a very zero-sum thing. That’s not curing disease or cool piece of software. And the idea you know of looking at volume curves, it doesn’t invent anything. So I thought my way of looking at the world, what I wanted to figure out and do to what he looked at, it wouldn’t be much intersection. And that’s why it was so shocking when I met him. He was the first person to really ask me about software, and software pricing, and why wasn’t IBM with all of their strength able to overwhelm Microsoft. What was gonna happen in terms of how software would change the world? And, you know, he let me ask him about why do you invest in certain industries, and why are some banks more profitable than others. Yet, he was clearly a broad systems thinker. And so it started a conversation that has been fun and enriching. You know, an incredible friendship that was completely unexpected.

DAVID ROSENSTEIN: He taught you how to play bridge or did you already know?

BILL GATES: I knew how to play bridge but I hade done it just… our family had done it. And then because it was a chance to spend time with Warren I renewed my bridge skill, at first really poorly. But both golf and bridge were things that we did in our hours that we got to goof off together.

DAVID ROSENSTEIN: You’ve given up on golf?

BILL GATES: Well, Warren gave up on golf a few years ago. So my primary excuse to play golf has gone away, so I’m golfing not much now. Tennis has become my primary sport.

DAVID ROSENSTEIN: Warren Buffett called you one day and said: “By the way, I’m gonna give you most of my money.” Were you surprised when he said he wanted to give you all his money from his wealth to your foundation?

BILL GATES: That was a complete surprise because Warren is the best investor, and he’s built this unbelievable company, and he was giving me advice about all the things I was doing. I was learning so much from him. But his wealth was devoted to a foundation that his wife was in charge of. And so tragically she passed away, and so then he had to think that his initial plan wouldn’t make sense. And much to my surprise he decided that a part of his wealth, a little over 80 percent would come to our foundation. So it was a huge honour, a huge responsibility, and an incredible thing because it let us raise our level of ambition even beyond what we would have done without that. You know, by most definitions, the most generous gift of all time.

Click here to see the whole interview.

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A Road Map for Investing: Warren Buffett’s Ground Rules

“Buffett leaves us a road map that is invaluable for students and investors alike. It’s as if he’s laid down a challenge to all of us. It’s as if he has written the letters, made them public, and said, ‘Here’s how to invest, here’s how I did it; this is the road I took. Now, let’s see if you can follow me down the path.” 

—Jeremy Miller, author of Warren Buffett’s Ground Rules

A Road Map for a Road Less Traveled

Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor is written by Jeremy Miller and was released in 2016. The book consists of three parts, all of them discussing and summarizing the most important things from Warren Buffett’s Partnership Letters, letters written by Warren during the Partnership era in 1959-1970.

Here’s what I like the most about this book.

  • The Ground Rules. “These ground rules are the philosophy. If you are in tune with me, then let’s go. If you aren’t, I understand.” (p. xii)
  • Structure and the fee setup of the Buffett Partnership. “The interest provision was set at 6% for everyone, beyond which Buffett would take 25% of the gains. Since he figures the market was going up 5-7% a year on average, the interest provision was set at a level so he earned nothing unless he was beating the market. He had a “high-water mark”—any cumulative deficiency below a 6% annual gain would have to be recouped before he would resume taking fees.” (p. 59)
  • Alignment of manager incentives and investors. “If you want your investment manager to behave with your best interests in mind, you have to ensure that your interests are aligned. Buffett was masterfully aligned with his investors.”
  • Investment categories. From the beginning Warren utilized three categories to describe the investment operations to his partners: Generals-Private Owner, Workouts, and Controls. In January 1965 he added another one—Generals-Generally Undervalued—to reflect his “…further consideration of essential differences that have always existed to a small extent with our ‘Generals’ group.”

Inside the Book: An “Investment” Treasure

The book is divided into three parts, each containing a few chapters. Each chapter ends with a few excerpts from the Partnership letters that have been discussed by the author earlier in the chapter.

  • Part I lays out the investment principles and ground rules employed by Warren between 1956-1970. It also describes the Partnership structure and the fees that all partners paid to Warren based on the investment returns realized each year.
  • Part II explains the different investment categories. In the beginning there were three; Generals-Private Owner, Workouts, and Controls. A fourth category was added later on: Generals-Relatively Undervalued.
  • Part III contains a few different topics, all related to investing; “Conservative Versus Conventional,” “Taxes,” “Size Versus Performance,” “Go-Go or No-Go,” “Parting Wisdom,” and “Toward a Higher Form.” Each one of the chapters touch upon important questions to consider for an investor, and at the same time shows what Warren’s thoughts looked like in these areas.

The Ground Rules

At a dinner at the Omaha Club where the Partnership’s first members gathered, Buffett focused on the thing that he thought to be of most importance; the Ground Rules—this to make sure that all of the partners understood and accepted the rules that Warren was going to follow when carrying out the investment operations for the Partnership.

Click image below to read an excerpt of “The Ground Rules.” These rules were first published in writing by Warren in his Partnership Letter from January 18, 1963. To read this letter, click here.

Structure and fee setup of Buffett Partnership

The fee structure set by Warren for the Partnership was; 1) no management fee, 2) no fees paid by partners for any annual investment returns up to 6%, and 3) above 6% Buffett would take 25% of the gains.

The fee structure of the Partnership is a bit different compared to many of today’s hedge funds and mutual, something that is discussed by the author himself in the book.

The fee structure can be compared to “Today’s hedge funds and mutual funds that typically charge a management fee, compounded as a fixed percentage of the investor’s assets under management. These can range from .25% to 2% or more, per year, and the fee is taken irrespective of performance.” Also, “Because the as asset management business is highly scalable—an increase in assets usually requires few additional costs—the more funds under management, the more profitable the asset manager will be. While performance is certainly a key component of a fund’s ability to grow, a great marketing effort can bring in new investors and has the ability to drive asset growth even faster. Most asset managers—particularly mutual fund companies—earn fees, and therefore are incentivized to maximize the size of their total assets. Fees based on a fixed percent of assets under management make it hard for asset managers to say no to the incremental dollar of investor capital, even when it’s clearly going to have a dampening effect on performance. When an investor’s primarily interest (annual percentage gains) is out of step with the primary interest of the manager (more assets, more fees), a potential conflict exists. Buffett charges no management fee. He got paid only for performance. His system was better because it removed a source of potential conflict between his interest and the interest of the LPs [Limited Partners]. (pp. 59-60)

Buffett’s Four Investment Categories

Buffett employed three principal types, or categories, of stock picking that he referred to as; Generals, Workouts, and Controls. These three categories define Warren’s investment style during the Partnership era.

Talking about portfolio composition, “Buffett typically committed 5-10% if his total assets in five or six Generals with smaller positions in another 10-15%. Concentrating on his best ideas was another key component of his success.” The maximum size on any single investment was revised upwards in 1965 when the rules was amended to allow as much as 40% of the portfolio in a single General (hint… American Express). The amount of assets used for Workouts “…in most years […] made up 30-40%.”

Here are the categories used by Warren during the Partnership era to explain and describe the investment operations conducted by him to his partners.

  1. Generals-Private Owner. “‘Generals’—A category of generally undervalued stocks, determined primarily by quantitative standards, but with considerable attention also paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issues lack glamour or market sponsorship. Their main qualification is a bargain price; that is, an overall valuation on the enterprise substantially below what careful analysis indicates its value to a private owner to be.” (BPL, January 18, 1964)
  2. Generals-Relatively Undervalued. “…this category consists of securities selling at prices relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept.” (BPL, January 18, 1965)
  3. Workouts. “These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs.” (BPL, January 24, 1962)
  4. Controls. “The final category is ‘control’ situations where we either control the company or take a very large position and attempt to influence policies of the company.” (BPL, January 24, 1962)

Each of the sub-chapters about the different investment methods also includes examples of investments that Warren made. For Generals, only one was ever named explicitly; Commonwealth Trust Company, and this only in order to illustrate the type of stocks Warren was buying in this category. In 1964, the same year as Warren introduced the new category—Generals-Relatively Undervalued—he also made his now famous investment in American Express. Another example of Generals was Walt Disney. The most important characteristic of the investments in the Generals-Relatively Undervalued category was that they produced magnificent profits year in and year out, and that Warren potentially could hold them for a very long time, compared to most Generals-Private Owner investments with their one free puff.

Warren outlined four critical questions needed to evaluate these kinds of investments, i.e, Workouts: “(1) what chance does the deal have of going through, (2) how long will it take to close, (3) how likely is it that someone else will make an even better offer, and (4) what happens if the deal busts?” One example of a Workout was the investment in Texas National Petroleum. The Workouts were expected to do as well as the Generals (10 points better than the market, or 15-17% per year on average). They not only produced solid, fairly stable returns, but their success was largely independent of the DOW and so insured BPL’s overall performance in down markets.

Warren also invested in companies like the Sanborn Map Company, Dempster Mill Manufacturing Company, and Berkshire Hathaway, all examples of businesses in the Controls category.

I enjoyed this book, and I would say it’s a great one. I like the way the partnership letters have been reorganized into topics, so that you get everything from the letters regarding a certain topic in one chapter. This is pretty much the same setup as in The Essays of Warren Buffett, with the only difference being that the essays focus on the Letters to Shareholders written by Warren during the Berkshire Hathaway era that started in 1970 when the Partnership years ended.

Checklist for Evaluating Generals

“We’re generally overconfident in our opinions and our impressions and judgments.”

—Daniel Kahneman

Different Weather Requires Different Clothing…

In his Partnership Letters Warren Buffett discusses four different investment methods used by him in order to best act in accordance with his investment principles. The methods are: (1) Generals-Private Owner, (2) Generals-Relatively Undervalued, (3) Workouts, and (4) Controls.

In Buffett’s Ground Rules, written by Jeremy Miller, the author provides the following checklist as a tool for evaluating a potential investment in a General, i.e., both Generals-Private Owner and Generals-Relatively Undervalued.

Here is a checklist for evaluating a potential investment in a General: (1) Orient: What tools or special knowledge is required to understand the situation? Do I have them? (2) Analyze: What are the economics inherent to the business and the industry? How do they relate to my long-term expectations for earnings and cash flows? (3) Invert: What are the likely ways I’ll be wrong? If I’m wrong, how much can I lose? (4) What is the current intrinsic value of the business? How fast is it growing or shrinking? And finally, (5) Compare: does the discount to intrinsic value, properly weighted for both the downside risk and upside reward, compare favorably to all the other options available to me? 

I enjoy reading Buffett’s Ground Rules, and one third into it I can highly recommend it. In this book the author provides a compilation of the old Buffett Partnership letters, and discusses different investment principles, methods, and digs into some of the investments made by Buffett during the 1956-1969 era.

The author then goes on to provide some insight about what to do when you’re not able to clear each paragraph in the checklist.

If you find yourself unable to make it all the way through the checklist, then write down in a single paragraph the metrics of the investment. If you get caught up along the way, either do more work or simply forget the idea as “too hard” and move on to something else.

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Warren Buffett’s Ground Rules

“…I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.”

—Warren Buffett, January 18, 1963

Ground Rules, Partners, and Reasonable Expectations

I am currently reading Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, authored by Jeremy Miller. This book contains, for the first time, a compilation of Warren Buffett’s Partnership letters, and Buffett’s own words written to his partners about his investment principles, for example his view on diversification strategy, compounding interest, preference for conservative rather than conventional decision making, and his goal and tactics for bettering market results by at least 10% annually. Demonstrating Buffett’s intellectual rigor, they provide a framework to the craft of investing that had not existed before: Buffett built upon the quantitative contributions made by his famous teacher, Benjamin Graham, demonstrating how they could be applied and improved.

I have read the Buffett Partnership Letters before, and they are well worth reading. In one of the letters, dated January 18, 1963, Buffett lays out his “Ground Rules.” These rules provide a great example of how to make sure that partners have reasonable expectations about what results could be expected from the Partnership itself, and Buffett himself as the sole investment manager. For this reason I wanted to put the rules up on the blog to keep them with me on my investing journey.

“The Ground Rules” written by Buffett in a letter to his partners in the beginning of 1963 are as follows.

The Ground Rules

Some partner have confessed (that’s the proper word) that they sometimes find it difficult to wade through my entire annual letter. Since I seem to be getting more long-winded each year, I have decided to emphasize certain axioms on the first page. Everyone should be entirely clear on these points. To most of you this material will seem unduly repetitious, but I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.

  1. In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that—withdrawing. If we earn more than 6% per annum over a period of years, the withdrawals will be covered by earnings and the principal will increase. If we don’t earn 6%, the monthly payments are partially or wholly a return of capital.
  2. Any year in which we fail to achieve at least a plus 6% performance will be followed by a year when partners receiving monthly payments will find those payments lowered.
  3. Whenever we talk of yearly gains or losses, we are talking about market values; that is, how we stand with assets valued at market at yearend against how we stood on the same basis at the beginning of the year. This may bear very little relationship to the realized results for tax purposes in a given year.
  4. Whether we do a good job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.
  5. While I much prefer a five-year test, I feel three year is an absolute minimum for judging performance. It is certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
  6. I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in my partnership.
  7. I cannot promise results to partners. What I can do is that:
    1. Our investments will be chosen on the basis of value, not popularity;
    2. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments, and
    3. My wife, children and I will have virtually out entire net worth invested in the partnership.

To read the full Buffett Partnership letter quoted above, click here.

To read a sample from the book Warren Buffett’s Ground Rules, click here.