Book Review: 'The Warren Buffett Way'
According to Robert Hagstrom, his second book, "The Warren Buffett Portfolio," is meant to be a companion, not a sequel, to "The Warren Buffett Way." He claimed he unwittingly passed lightly over two important areas: portfolio management and intellectual fortitude in The Warren Buffett Way. It gives the reader tools to pick common stocks wisely, and The Warren Buffett Portfolio shows you how to organize them into a focus portfolio and provides the intellectual framework for managing it.
I introduce readers to Hagstrom's first book, The Warren Buffett Way.
Takeaways from The Warren Buffett Way
Business Tenets = basic characteristics of the business itself
1. Is the business simple and understandable?
- Understand the revenues, expenses, cash flow, labor relations, pricing flexibility, and capital allocation needs of every single one of your holdings.
- Investment success is not a matter of how much you know but how realistically you define what you don’t know.
2. Does the business have a consistent operating history?
- A steady track record is a relatively reliable indicator. When a company has demonstrated consistent results with the same type of products year after year, it is not unreasonable to assume that those results will continue.
- Avoid purchasing companies that are fundamentally changing direction because their previous plans were unsuccessful. Undergoing major business changes increases the likelihood of committing major business errors.
- Avoid businesses that are solving difficult problems. Turnarounds seldom turn.
3. Does the business have favorable long-term prospects?
- A franchise as a company whose product or service 1) is needed or desired, 2) has no close substitute and 3) is not regulated.
- A franchise that is the only source of a product people want can regularly increase prices without fear of losing market share or unit volume.
- A franchise has the ability to survive economic mishaps and still endure. A great company is one that will be great for 25 to 30 years
Management Tenets = important qualities that senior managers must display
4. Is management rational?
- The most important management act is allocation of the company’s capital.
- Deciding what to do with the company’s earnings — reinvest in the business, or return money to shareholders — is an exercise in logic and rationality.
- If the extra cash, reinvested internally, can produce an above-average return on equity — a return that is higher than the cost of capital — then the company should retain all its earnings and reinvest them.
- A company that provides average or below-average investment returns but generates cash in excess of its needs should return the money to shareholders.
- Dividends put reinvestment risk in the hands of shareholders.
- Repurchases are preferred as shareholders are rewarded twice, first from the initial open market purchase and then from the positive effect of investor interest on price.
5. Is management candid with its shareholders?
- Likes managers who report their companies’ financial performance fully and genuinely, who admit mistakes as well as share successes, and who are in all ways candid with shareholders.
- Data should be disclosed in a manner that helps the financially literate readers answer three key questions: 1) Approximately how much is this company worth? 2) what is the likelihood that it can meet its future obligations? and 3) how good a job are its managers doing, given the hand they have been dealt?
- Managers who confess mistakes publicly are more likely to correct them.
- The CEO who misleads others in public may eventually mislead himself in private.
6. Does management resist the institutional imperative?
- The institutional imperative is the lemming-like tendency of corporate management to imitate the behavior of other managers, no matter how silly or irrational that behavior may be.
Financial Tenets = critical financial decisions that the company must maintain
7. What is the return on equity?
- Make adjustments to ROE. All marketable securities should be valued at cost and not at market value and excludes all capital gains and losses as well as any extraordinary items that may increase or decrease operating earnings.
- A business should achieve good returns on equity while employing little or no debt.
The adjustments suggested are similar to those points I have noted in my article, "Why High ROE Screens Are Not the Perfect Way to Find Warren Buffett-Style Investments."
8. What are the company’s “owner earnings?"
- “Owner earnings” = a company’s net income plus depreciation, depletion and amortization, less the amount of capital expenditures and any additional working capital that might be needed.
9. What are the profit margins?
- Managers of high-cost operations tend to find ways that continually add to overhead, whereas managers of low-cost operations are always finding ways to cut expenses.
- Relentless attack on unnecessary expenses, abhor having a bigger head count than is needed.
10. Has the company created at least one dollar of market value for every dollar retained?
- Subtract all dividends from a company’s net income over the last ten years to get the total retained earnings figure. Add total retained earnings to the company’s market value at the beginning of the 10-en year period to get Total A. If the company has employed retained earnings effectively, the market value at the end of the 10-year period will exceed Total A.
Value Tenets = two interrelated guidelines about purchase price
11. What is the value of the company?
- Value of a business is the total of the net cash flows (owner earnings) expected to occur over the life of the business, discounted by an appropriate interest rate.
- If you are unable to project with confidence what the future cash flows of a business will be, don't attempt to value the company.
- Discount rate used is the risk-free rate for long-term government bonds.
- Does not add a risk premium. Instead, relies on single-minded focus on companies with consistent and predictable earnings.
12. Can it be purchased at a significant discount to its value?
- Margin of safety concept