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So, you want to invest like Warren Buffett?

The Warren Buffett Way is an excellent read for long-term investors who want to invest like Buffett. The book discusses many of Buffett's investments and gives us an idea of how he invests.

Buffett says he values a business by discounting net annual future cash flows the business is expected to generate at an appropriate discount rate to get the present value of the business.

For example, suppose that we feel an appropriate discount rate is 10%. If we are to receive $100 at the end of a year, that future $100 is currently only worth $100/1.1 = $90.91. This is because, if we had $90.91 at present, we could invest it to receive $100 in one year, if we achieve a 10% rate of return.

Similarly, if the $100 is to be received in two years, and we assume an appropriate discount rate is 12%, the $100 to be received then is only worth $100/(1.12)(1.12) = $79.72.

Using this basic concept, we can derive formulas for varying assumptions, such as annual cash flow growing at a given rate. For example, if we are to receive $100 each year forever and we assume a discount rate of 10%, the investment is worth $1,000. That's the common annuity valuation.

The Warren Buffett Way doesn't go into the mathematical detail of such calculations. If you're looking for a book that discusses discount cash flow or dividend yield calculations, I recommend either my own book, Becoming An Investor or Investments by J. Peter Williamson, which unfortunately is out-of-print. The topic of discounting future cash flows to the present is also covered in many college investment classes.

Two important caveats should be noted. First, Buffett says he uses the rate of long-term U.S. government bonds as the discount rate (i.e., he uses a fixed value for all investments). Most academics argue that you must adjust the discount rate for the risk of the investment in question. However, anyone who's ever done these calculations will immediately realize that there is no adequate way to match discount rate with risk and that the values are all over the map once you start varying discount rate to allow for risk. So, despite the theoretical, academic arguments that the discount rate you demand for a specific investment must take into consideration the risk of the investment, there's no way to adequately quantify real investment risk and properly incorporate it into these evaluations via the discount rate.

This brings us to the second caveat. Buffett claims that he only invests in businesses where he is confident he can make estimates of cash flows of a business with a high degree of accuracy. Thus, he essentially is incorporating risk factors into the cash flow amounts, rather than the discount rates. This seems the logical way to use these future discount calculations in the real world.

That said, I'm not confident the average investor will make adequate use of these calculations. First, estimating a business's future profitability or future net cash flows isn't easy. For most businesses, these estimates are nearly impossible. (It would be fun to see how closely Buffett's personal calculations agree with achieved results.) And, many of the most profitable businesses in the future will be high-tech companies where predictions of future profitability are especially difficult.

Although we can always adopt Buffett's search for quality and value, it would be wrong to assume that today's information-development companies can be evaluated exactly like the industrial, service, and information-distribution companies upon which Buffett created his wealth. The uncertainties in the net cash flow are just too great once we look a few years into the future for high-technology companies.

For example, it's possible three kids at a start-up biotech company could create a product that kills the profitability of an established biotech company's premier product. Coke-a-Cola doesn't have anything to worry about from such young upstarts, and its annual profits can be more easily estimated and are more assured. In this sense, investing forty years ago was quite different than investing today. (I'm not so sure if Buffett were to be around another forty years that he could beat the market averages while avoiding high technology. The area is just too high growth.)

It's important to point out that Buffett has an advantage in the sense that he's on the phone talking with the CEOs and other key people of the companies in which he invests. He's connecting with them socially. And, he has strong loyalty to management which shares his views. Buffett has a lot of influence. What do you think the chances are of a CEO remaining if Buffett suggests replacing him/her at the annual meeting? That probably means company insiders will cooperate with Buffett by answering his questions about the business, etc. Plus, Buffett stands ready to make large loans to a company. That access is something the average investor lacks.

The average investor will be relying upon only the most public of company reports to make such calculations (Joke: What's the difference between unaudited and audited financial reports? Mark Twain probably would have said it best if he had contemplated the topic: Unaudited reports are lies! Audited reports are damn lies!). If the average investor asks the CFO of a public company to explain exactly what footnote xxx means, he'll probably get the run around. Never mind that it's a $2 billion footnote! Would Buffett get the same response?

And, Buffett isn't eager to share what he knows about a company with the public. Quoting from a recent Associated Press article, "Buffett,..., routinely requests to seal portions of quarterly filing reports with regulators, who have increasingly been reluctant to grant the request."

That said, back before Buffett was well-known as an investor, he probably didn't possess any particular access to information or corporate insiders, and he did well. He relied upon basic business analysis. And, that's something every investor can seek to emulate. What makes this company profitable? Does it have quality products and services? What is its competitive advantage?

While Buffett was initially influenced by the Ben Graham (The Intelligent Investor) school of thought, he later was far more influenced by the Philip Fisher school of thought. (Common Stocks And Uncommon Profits). This second school of thought was also adopted by Charlie Munger (Damn Right Book), Buffett's sidekick.

This brings up another factor that Buffett adopted from the Graham school of thought--margin of safety. Suppose you buy a business that you've valued at $100 per share for a price of $100 per share. You have no margin of safety if your valuation is off or if something bad happens to the business to devalue it. But, if you seek to buy the business when it's selling for $50 per share, you have a margin of safety. You're investment is safer and you have more gain to expect. Of course, the time to buy is when everyone is selling in fear and panic. I just saw an AP article that Buffett is aggressively buying now (August 3, 2002).

Anyway, I think Hagstrom's book is an excellent introduction to Buffett's strategy. However, if you're looking for the tactics to implement such a strategy, you'll need to read further. I highly recommend Buffett: The Making Of An American Capitalist by Roger Lowenstein if you want to learn more about Buffett, personally.

Also, and this may sound slightly odd advice for investors, but I'd recommend reading some books about buying an entire smaller business. That will give you insight into the analysis and records examined by someone buying a small business. All records and competitive questions are fair game then. No one can say: "Oh, no, we can't give you that information." (if they do, you walk away) Unfortunately, the only records you'll probably get as an investor in publicly-traded companies are the records mandated by the SEC. And, as we know, those records leave a lot to be desired! When it comes to valuation methods, GIGO applies. If garbage goes in, garbage comes out.

Peter Hupalo, Author of
Becoming An Investor
Building Wealth By Investing In Stocks, Bonds, And Mutual Funds

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