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Buffett's Secret Investment Formula

January 22, 2009
guruyt

Todd N Kenyon

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As one of the most successful investors ever, Buffett's methods are widely studied and many attempt to replicate them. Mr. Buffett has frequently discussed his investing criteria and the influence Ben Graham had on him in the early days. He has repeatedly said over the decades that value investing is simple, but not easy.

So just how simple is Buffett's investing methodology? There are many stories out there that Buffett does not use a computer (other than to play bridge online), hence he does not use the ubiquitous Wall Street crutch, the spreadsheet financial model. Buffett also doesn't use a calculator. Maybe it's that Buffett is just so darn sharp that his brain is the only calculator he needs.

There is no doubt Buffett is super sharp, and able to see what matters and quickly and efficiently evaluate it. But, I think that is just a bonus for Buffett - not a requirement to practice his investing style. He would agree I think since he has frequently stated that investing success only requires an average IQ. Certainly we are now very familiar with the damage done by those who supposedly have superior IQ's.

Alice Schroeder recently released "The Snowball", the most complete account of The Man to date (and next on my reading list - if I only had any time to read books). Ms. Schroeder had unprecedented access, spending years in Buffett's office going through his old files. How did she gain Buffett's approval? Through her work as an insurance analyst a decade ago for Paine Webber and Morgan Stanley. Her reports from that era on Berkshire are the only coherent analyst reports on Buffett's empire that I have ever read. And her valuation model for Berkshire was the best I've seen. I still use my own version of it. I think she won the Buffett lottery because she was the only one who "got" Berkshire on Wall Street.

Schroeder recently gave a keynote at the Darden Value Investing Conference. In it she clearly laid out the Buffett's "secret" investment methodology. But first she also made it clear that Buffett is a unique animal. He asked for a book titled "Bond Salesmanship" for Xmas at age 7 and read it cover to cover. She describes him as someone who is always thinking "what more can I do", especially to get an edge on the other guy. And, he is a learning machine with a cumulative mental file cabinet. And he always thinks like a horse handicapper, he's always thinking about probabilities.

So what is Buffett's secret method? Here it is step by step:

1. Look at the risk of loss. What is the probabilty that I will permanently lose money here, and what could happen that would result in total loss? If there is ANYTHING that could reasonably result in a total loss, stop right there. Buffett never tries to talk himself into any investment. He says that much of his success is from immediately passing on things due to realistic appraisal of cat risk.

2. Look at historical financial data. Look at the historical quarterly sales, expenses and profits (and cash flow of course) for each line of business or operating unit. DO NOT build a model or try to predict the future. Schroeder says there was not one model of any kind in Buffett's files - just simple hand-written tables with historical financial data.

3. Once he's happy with the first two critieria, he sets his price. He "only" requires that he receive a day one return of 15%, with a good likelihood that his return will compound from there. Although Schroeder is not clear on this, I assume he looks at cash earnings or the so-called "owner's earnings" for his 15% return. Essentially this is cash from operation less one-time and options benefits minus maintenance or essential capital expenditures. So you could say he is looking to buy in at 6.67 (or less)x today's cash flow - something that's been nearly impossible up until September.

There you have it, Buffett's secret. Extreme simplicity that requires extreme discipline to execute. Buffett has the advantage of not having to answer to anyone. He says he gets up and looks in the mirror, then everyone has had their say for the day. Furthermore, he believes that 90% of being successful in business is guts: you must only answer to yourself. He can wait indefinitely for a good opportunity. This is in direct contrast to the typical money manager, who has to answer to clients, employers, media, and on and on. Hence Buffett's is largely an IMPOSSIBLE strategy to execute on Wall Street. However, as an individual investor you only have to wrestle with your own psyche, and that will be the hardest part of investing like Buffett.

What about future predictions?? Everyone knows the stock market is always looking 6 months ahead, always anticipating the future. Buffett says that the whole purpose of investing with Graham's infamous "margin of safety" is to render forecasting unnecessary. And margin of safety is ALWAYS a function of price paid - hence Buffet's 15% day one return requirement. Imagine if everyone invested this way. Even more Wall Streeters would be out of jobs: analysts, strategists, economists - worthless (not that they have any value now - they're just paid as if they do).

I plan on presenting a series of stock ideas over time in the premium blog that I think fit Buffett's "secret" method. There has been no better time in my 12 year investing career to look for such bargains. Sure it's tough out there, and anything you buy today will likely go down tomorrow. Buffett was recently interviewed by Tom Brokaw, and had this to say about how to deal with today's market, and how investors can steel themselves against the rampant fear and panic:

"If you own a farm nobody tells you when it's gone down 50 percent 'cause you don't get a quote every day. But you really look to the farm and what it produces to determine whether you made a good investment. Now if people look to the newspaper every day at the price of a stock to determine whether they made a good investment they're making a mistake.

They have to look to the business, the asset itself. If you own an apartment house you wouldn't get a quote on it every day. You'd just look at-- what the rent rolls were, and your taxes were and expenses were. And if they all came in with-- in line with what you expected when you bought it you'd feel you'd made a satisfactory investment, and you'd never get a quote on it. So I don't look at quotes. I can't tell you what Berkshire Hathaway is selling for today."

By Todd Kenyon

www.investorwalk.com

Rating: 3.5/5 (27 votes)

Comments

tkervin
Tkervin - 5 years ago
I remember one of the few times I have seen Buffett be openly sarcastic to someone. I don't remember the exact question but the answer was along the lines of........"another guy looking for a formula".
svoleti7
Svoleti7 premium member - 5 years ago
With all due respect, by his own admission, there are some simple formulas.

"Well, I can't tell you it's exactly the right time. I don't try to time things, but I do try to price things. And I've got a formula that says bet on brains, and bet of them when it's the right type of deal."

Amit Chokshi
Amit Chokshi - 5 years ago
WEB developed a valuation for GEICO based on his estimate of future expected earnings of GEICO when he was at Columbia. It's in Snowball and is mentioned how it starkly contrasted with Graham's approach. You can't have it both ways, you can't talk about Margin of Safety and not consider the future of a company. Look at MSFT, how would you calculate the MOS for that in 2004 vs now vs 2012?

What about another value trap with SHLD. When determining a good buy in price that establishes a good MOS, what is the real estate valued at? MOS are very fluid and last for short periods of time. A stock might have a decent MOS now but that could erode in 12 or 5 years, who knows.

If you have a wheel company like SUP, it has plenty of cash and PPE consists mostly of wheel plants of which some are in California. Does any one want wheel plants in CA? What is a good MOS if you're not going to consider the futuer performance of the business.

The difference between WEB and us is the same as the difference between Tiger Woods, Michael Jordan, the Beatles, Bill Gates, Beethoven. They got interested and involved in their chosen field at an early age and practiced like crazy.

When the Beatles were first considered "new" they had played for 3-4 years in Germany and over 1,200 shows on the garbage club circuit. By then they had tried all sorts of music and knew each other's playing styles inside and out.

Bill Gates was working with the most advanced computers in the 1960s due to his parents enrolling him in a big time private school and was obsessed with programming. How much of an advantage did that produce for him when he was at Harvard?

WEB had read stacks of business books before going to college. How many of us have done that. WEB had a net worth of $53k (inflation adj) when he was 16 from his newspaper efforts. He is a genius when it comes to math and probabilities which is why he doesn't need to do models.

Eddie Lampert isn't an idiot, he may be underperforming but he is known for massive financial models that consider various scenarios. Is it bad then for investors to emulate Lampert?

The biggest risk the average investor faces is trying to emulate WEB on the things he does that seem "easy" when not considering the major work he puts in on other things. Some people say WEB doesnt do models so I don't need to. WEB's seen countless more businesses, operating models, and scenarios across industries than most people so it's safe to say he can leverage the decades of that experience to make judgements faster and more accurately than us. That doesnt mean we should not run financial models, I find thinking about all parts of a company's financials can help better understand it. Rather than focus on what WEB doesn't do, investors should focus on what he does and that is pour over financial statements and companies all of the time.

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