WARREN BUFFET AND PHILIP FISHER'S PROVEN SECRETS OF A STOCK BILLIONAIRE ON How To Become The Best Stock Trader

Buffett: A Life in the Stock Market

Warren Buffett is widely acknowledged to be the best investor of our time. When John C. Bogle, founder of the Vanguard Group, named three investors who seem to have been able to beat the market because of their special gifts, they were Buffett, Peter Lynch (formerly of Fidelity Magellan), and John Neff (formerly of Vanguard Windsor). In the 36 years that Buffett has been the chairman of Berkshire, its per-share book value has climbed more than 23 percent a year. (The change in value is the best way to evaluate an insurance company’s performance.) In 32 of those 36 years, Berkshire has beaten

the S&P, sometimes by astonishing amounts. The stock has risen from $12 a share

It’s Easy to Invest like Warren Buffett

Buying shares of Berkshire Hathaway is the easiest way to invest like Warren Buffett. While the A shares cost around $70,000 apiece as of this writing, the B shares sell for only around $2,300 each— roughly 1/30 of the A shares. The B shares do have their disadvantages. For example, holders have less in the way of voting rights and aren’t entitled to indicate where Berkshire charitable contributions go. (Berkshire is unusual in allowing shareholders to recommend

how Berkshire’s charity money should be allocated.) And while you can convert A shares into B, it doesn’t work the other way around. Which to buy? Berkshire is nothing if not shareholder friendly, and Buffett has given this advice: Buy the A shares, if you can afford them, unless the B shares are trading cheaply. “In my opinion, most of the time the demand for B will be such that it will trade at about 1/30 of the price of the A. However, from time to time, a different supply–demand situation will prevail and the B will sell at some discount. In my opinion, again, when the B is at a discount of more than, say, 2 percent, it offers a better buy than A. When the two of them are at parity, however, anyone wishing to buy 30 or more B should consider buying A instead.”

Buffettology or Mythology?

People with an ax to grind may be dubious of Buffett’s accomplishments, and one ax they typically are seeking to have ground is their adherence to the Efficient Market Hypothesis, the notion that stocks are always reasonably priced because all information about all companies is immediately dispersed to the general populace, and the general populace is composed of equally intelligent, rational individuals.

In some ways Warren Buffett resembles another plainspoken, outspoken,

ordinary-but-not-so-ordinary Midwesterner: President Harry Truman. This is so even though Truman, after having been burned in a zinc mining adventure, mostly confined his investing to Treasuries. Many of the terms used to describe Truman describe Buffett equally as well. Historian David McCullogh called Truman a man “full of the zest of life.” Others talked about his “fundamental small-town genuineness,” and his “appealing mixture of modesty and confidence.” Much like Buffett, Truman was known for his integrity and character, and for being scrupulously ethical. These traits seem to have served Buffett and Truman equally well. Warren Edward Buffett was born in Omaha on August 30, 1930, the son of Howard Buffett, a stockbroker and later a Republican congressman. He was the second of three children, and the only son. From his father Buffett learned the basic moral values, possibly along with a deep respect for people who have money—his father’s clients. From his mother, who was difficult and disapproving, he may have developed a strong need to prove his worth, perhaps by accumulating a large fortune. In his youth Buffett displayed his intellectual gifts by memorizing the populations of scores of U.S. cities. He displayed his commercial instincts by selling chewing gum to passersby, setting up a lemonade stand, selling cans of soda pop, even selling a tip sheet at the track. He played Monopoly for hours. When he was 11, he began working in his father’s brokerage firm, marking prices on a blackboard. He bought his first stock when he was 11: three shares of Cities Service Preferred, at $38 a share. The price fell to $27, then bopped up to $40, at which point he sold. His profit was $6, minus commissions. The stock soon rose to $200 a share; perhaps Buffett had learned a lesson in being patient. When his father was elected to Congress, he took his family to Fredericksburg in Virginia. Warren, who all his life has been upset at the prospect of change, was wretched. He was allowed to return to Omaha and live with his grandfather, Ernest. Later, he worked in his grandfather’s grocery store. Buffett returned to Washington, D.C., as a teenager. He began delivering the Washington Post and other newspapers, and in 1945, at 14, took his savings from his paper routes and bought 40 acres of Nebraska farmland for $1,200 and leased them to a farmer. He also made money by searching for lost golf balls on a golf course, and by renting old, repaired pinball machines to barber shops. In high school, he was something of a nerd; he wore the same

His Picture in the Paper sneakers all the time, even in the dead of winter. But he had developed such a reputation for stock-market wisdom that even his

teachers would ask him for advice. He graduated high school 14th in his class of 374, and the yearbook described him this way: “Likes math . . . a future stockbroker.”He went on to the Wharton School of Finance, where, Warren reported, he knew more than his professors. And, indeed, he was a standout student. After a year, he transferred to the University of Nebraska in Lincoln. He himself dabbled in charting and technical analysis, but then, while a senior at the University of Nebraska, read Benjamin Graham’s The Intelligent Investor, advocating that investors buy good, cheap companies and hang on—and the veils promptly fell from his eyes. At 19 Buffett applied to and was turned down by the Harvard Business School, surely a blunder as egregious as the Boston Red Sox’s selling Babe Ruth to the Yankees. He then moved to New York to study with Ben Graham at the Columbia Business School. He was a splendid student. After getting his M.B.A., Buffett applied for a job with Graham’s firm, offering to work for no pay, but was turned down. Buffett wasn’t

resentful: He joked that Graham had “made his customary calculation of value to price and said no.” At the same time that Howard Buffett lost his seat in Congress, Warren received a phone call from Ben Graham. He offered Buffett a job as an analyst with Graham–Newman in the Chanin Building on

43rd Street. There Buffett shared a room with Walter Schloss (Chapter 26), and later with Tom Knapp, who started the Tweedy, Browne funds (Chapter 24). Although he admired Graham, Buffett complained that he “had this kind of shell around him.” Graham also didn’t really say yes to Buffett’s proposed stock picks—or anyone else’s. He also discouraged Buffett from visiting companies and talking to management. Either a stock fit Graham’s mathematical matrix or it didn’t. Buffett began courting Susan Thompson, and when she didn’t return his affection, befriended her father. Susan was dating Milton Brown, a Jew, and Susan’s parents—her father was a Protestant minister— were disapproving. Buffett told Susan’s father that he was Jewish enough for Susan and Christian enough for him. (“Jewish enough for Susan” probably meant: He was unconventional and iconoclastic.) Eventually Susan gave in to her father, and began dating Buffett; they married in 1952.

BUFFETT: A LIFE IN THE STOCK MARKET

In 1956 Graham retired to California, and Buffett—now worth $140,000 thanks to shrewd investing—returned to Omaha. There, Buffett began working in his father’s business. The first stock he sold: GEICO. Then he started his own investment partnership. He persuaded a group of investors to hand over $25,000 each; Buffett contributed $100, and he was on his way. His goal: to beat the Dow Jones Industrial Average by an average of 10 percent a year. When he ended the partnership in 1969, because he couldn’t find cheap stocks to buy, his investments had compounded at 29.5 percent a year versus the Dow’s mere 7.4 percent a year. Ending the partnership was a good call. The Dow plunged in 1973 and 1974. Buffett suggested that his ex-partners invest money with his friend Bill Ruane in a new mutual fund called Sequoia. (See Chapter 21.) In 1962, Buffett had begun buying cheap shares of a textile mill in

New Bedford, Massachusetts, called Berkshire Hathaway. He began buying it at less than $8 a share, then took it over completely in 1964, when its book value was $19.46. He had promised to hold onto the textile mill, but eventually had to give it up because the business was eroding thanks to foreign

competition. He then went into insurance, a wise decision because insurance

Graham’s 10 Signs of a Bargain Stock

A company would have to meet seven of the following ten criteria (as laid out in Security Analysis) before Graham would consider it a cheap stock

1. An earnings-to-price yield (the opposite of the price-earnings ratio) that is twice the current yield of an AAA (top-rated) bond. If bonds are yielding 5 percent, the earnings yield of a stock should be 10 percent. In other

words, you could get 5 percent fairly safely; to take on the risk of a stock, you want twice the possible reward.

2. A p-e ratio that is historically low for that stock. Specifically, it should be

two-fifths of the average p-e ratio the shares had over the past five years.

3. A dividend yield of two-thirds of the AAA bond yield. (Obviously, stocks

that don’t pay dividends wouldn’t qualify under this rule.)

4. A stock price that is two-thirds of the tangible book value per share.

5. A stock price that is two-thirds of the net current asset value or the net quick-liquidation value.

6. Total debt lower than tangible book value.

7. A current ratio of two or more.

8. Total debt that’s not more than net quick-liquidation value.

9. Earnings that have doubled within the past ten years.

10. Earnings that have declined no more than 5 percent in two of the past ten years.

The individual investor, Graham counseled, should adapt these rules to his or her own situation

• If an investor needs income, he or she should pay special attention to rules

1 through 7—especially, of course, to rule 3, the one requiring high dividends.

• An investor who wants safety along with growth might pay special attention to rules 1 through 5, along with 9 and 10.

• An investor emphasizing growth can ignore dividends, but should pay

special attention to rules 9 and 10, underweighting 4, 5, and 6

PHILIP FISHER'S ADVICE ON BUYING COMPANY'S STOCKS

Fisher’s 15 Questions

1. Does the company’s product or service promise a big increase in sales for several years? He cautions against firms that show big jumps due to anomalous events, like a temporary shortage. Still, judge a company’s sales over several years because even sales at outstanding companies may be somewhat sporadic. Check on management regularly, to make sure it’s still top-notch.

2. Is management determined to find new, popular products to turn to when current products cool off? Check what the company is doing in the way of research to come up with the newer and better.

3. How good is the company’s research department in relation to its size?

4. Does the company have a good sales organization?

Production, sales, and research are three key ingredients for success.

5. Does the company have an impressive profit margin? Avoid secondary companies. Go for the big players. The only reason to invest in a company with a low profit margin is if there’s powerful evidence that a revolution is in the offing.

6. What steps is the company taking to maintain or improve profit margins?

7. Does the company have excellent labor and personnel relations? A high turnover is an unnecessary expense. Companies with no union, or a company union, probably have good policies—otherwise, they would have been unionized. Lots of strikes, and prolonged strikes, are obviously symptoms of sickness. But don’t rest easy if a company has never had a strike. It might be “too much like a henpecked husband” (too agreeable). Be dubious about a company that pays below- average wages. It may be heading for trouble.

8. Does the company have a top-notch executive climate? Salaries should be competitive. While some backbiting is to be expected, anyone who’s not a team player shouldn’t be tolerated.

9. Does management have depth? Sooner or later, a company will grow to a point where it needs more managers, ones with different backgrounds and skills. A good sign: Top management welcomes new ideas, even criticism, from below.

10. How good is a company’s cost analysis and accounting? Management must know where costs can be cut and where they probably can’t be cut. Most companies manufacture a large variety of products, and management should know the precise cost of one product in relation to others. One reason: Cheap-to-produce products may deserve special sales efforts.

11. Are there any subtle clues as to how good a company is? If a company rents real estate, for example, you might check how economical its leases are. If a company periodically needs money, a spiffy credit rating is important. Here, scuttlebutt is an especially good source of information.

12. Does the company have short-range and long-range plans regarding profits? A company that’s too short-term oriented may make tough, sharp deals with its suppliers, thus not building up goodwill for later on, when supplies may be scarce and the company needs a big favor. Same goes for treatment of customers. Being especially nice to customers—replacing a supposedly defective product, no questions asked—may hurt in the short run, but help later on.

13. Might greater growth in the future lead to the issuance of more shares, diluting the stock and hurting shareholders? A sign that management has poor financial judgment.

14. Does management freely own up to its errors? Even fine companies run into unexpected problems, such as a declining demand for their products. If management clams up, it may not have a rescue plan. Or it may be panicking. Worse, it may be contemptuous of its shareholders. Whatever the reason,

forget about “any company that withholds or tries to hide bad news.”

15. Does management have integrity? Does management require vendors to use brokerage firms owned by the managers themselves, or their friends or relatives? Does management abuse stock options? Put its relatives on the payroll at specially high salaries? If there’s ever a serious question whether

the management is mindful enough about its shareholders, back off.

What and When to Buy

Investors should put most of their money into fairly big growth stocks, Fisher maintains. How much is “most”? It could be 60 percent or even 100 percent, depending on the investor. In general, don’t wait to buy. Buy an outstanding company now. What if economists fret that a recession is coming, citing all sorts of worrisome numbers? Economic forecasting, Fisher argues, is so unreliable, you’re better off just ignoring it. He compares it to chemistry in the days of alchemy. Obviously, if you buy a growth company when it’s somewhat cheap, you’ll wind up doing better. So “some consideration should be given to timing.” For example, management might have made a mistake in judging the market for a new product, causing earnings and share price to fall off the table. Or a brief strike has hit the company. During this time, management was buying shares like mad, but the stock price kept retreating. Another good time to buy. Clearly, an investor must make sure that management really is capable— and that a company’s troubles are short lived, not permanent.

What if yours is a modest portfolio and you are nervous about stashing your savings into the stock market in one fell swoop? What if a business bust came along? Fisher advocates dollar-cost averaging—investing regularly over a period of time. Beginning investors, after having made a start buying big growth companies, “should stagger the timing of further buying. They should plan to allow several years before the final part of their available funds will have been invested.” Fisher advocates patience. “It is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens.” In other words, stay the course. You may just be a quicker thinker than other investors, and you’ll just have to wait until they catch up to you. Occasionally, he warns, it may take as long as five years for excellent investments to reward you for your perseverance. www.pickbetterstock.com

 

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