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Robert Abbott
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‘The New Buffettology’: How Buffett Avoids High-Tech Massacres

How to use market cap and earnings to assess a company

September 12, 2018 | About:

Although “The New Buffettology” was published in 2002, it contained little information about internet or high-tech stocks, which collectively transfixed most of the investing community in the 1990s and early 2000s. An exception would have been Intel (NASDAQ:INTC), cited as a negative case in chapter six.

Authors Mary Buffett and David Clark discuss this sector in chapter 7, but the chapter title gives away what they were thinking: “Using Warren’s Investment Methods to Avoid the Next High-Tech Massacre.”

A classic bubble, the internet stock bubble built up over the 1990s and then burst in early 2000. Investors who bought into the promise that earnings were not so important as potential growth were badly burned, even though it was “supposed to be different this time.”

Warren Buffett (Trades, Portfolio) watched from the sidelines, aware that once again investors were being charmed by the “visions of grandeur that accompany new industries that promise to reshape and transform society.” He had seen or read about such visions that came throughout the 20th century, including radio broadcasting, automobiles, airline and biotech bubbles.

Each of these industries, in its turn, had produced dreams of great and immediate wealth, leading investors to bid up share prices beyond their intrinsic values. As share prices continued to climb, those investors saw the run-up as validating their decisions, prompting them to buy even more shares. Outsiders saw others raking in easy money and threw their lot in, too, pushing stock prices even higher. And everyone believed until they woke up one morning and discovered the deal that was too good to be true really was not true.

The authors reported that 300-plus airline manufacturers went through the bubble process between 1919 and 1939—fewer than 10 survived in 2002. In the previous 20 years before 2002, 129 airlines had filed for bankruptcy. And, of course, many of those world-changing tech startups also disappeared when reality caught up with the dream.

From Buffett’s perspective, transforming industries seldom build durable competitive advantages because of the intense competition. Remember, as share prices roar higher, new producers also jump in, creating products or services in response to the clamor of investors for more investment opportunities. As a result, no company has enough free cash flow to build a durable advantage.

The guru also believes businesses in new industries go through “countless permutations” before arriving at a durable advantage. New businesses have no history of product durability and are doubly doubtful targets.

Nevertheless, Buffett likes to “hypothetically” buy such businesses in whole. He then assesses them. If a complete company is not worth purchasing at the current price, he refuses to buy even one share.

Turning to the practical application of this idea, the authors wrote, “To understand Warren’s whole business approach, you need to know how to calculate what is called the company’s stock market capitalization or, as it is commonly known, the company’s market cap.” To calculate the market cap, simply multiply the number of shares outstanding by the stock’s market price.

Buffett does this calculation and asks himself, “If the company in question had a market cap of $5 billion and I had $5 billion sitting in my bank account, would I use it to buy the whole company?” As a reference point, U.S. Treasury bonds were yielding 7% at that time, which would bring in $350 million annually.

How about Yahoo, which was still an internet market darling in March 2000? Its shares traded at $178, giving it a market cap of roughly $97 billion, and the company was expected to earn $70.8 million for the year, only about one-fifth as much as Treasury bonds.

Advocates for the new and exciting internet might argue Yahoo had infinitely more potential for growth than Treasury bonds. Buffett, however, would point out that until Yahoo began earning as much as the bonds, investors would incur an opportunity cost: the difference between what they could have earned with the bonds versus what they would receive from the company. In the first year, this would be the difference between $350 million and $70.8 million (which equals $279.2 million). That differential would continue to grow (and negatively compound) and could go on for years.

On the other hand, Buffett was reportedly buying Allstate (NYSE:ALL) at that time for approximately $18; it had a market cap of $13.4 billion. It also earned $2.2 billion, which would equate to a yield of 16.4% per year. If asked whether you would rather own Yahoo or Allstate, I’m quite sure I know how you would answer. Ironically, though, Allstate was trading at a discount at the time because many other investors wanted to invest in internet stocks.

It is important to note again that Buffett looks at buying whole companies, even if he does not do so. The “whole company” concept makes it easier to compare what kinds of returns can be expected from different investments. If it wouldn’t make sense to buy the whole company, then he would not buy a single share; on the flip side, if the stock meets his other criteria as well, he will buy as many shares as possible.

About the authors

Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor.”

(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website

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