Investing Like Buffett: How to Profit from the Wisdom of the "Oracle of Omaha" Part 1

	Paul Tracy Street Authority.com
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Born, raised and residing in Nebraska for most of his life, Warren Buffett is affectionately known to many as the "Oracle of Omaha."

Buffett remains the most successful and best recognized value investor in modern stock market history. And there's good reason for that fame. According to the Forbes list of wealthiest people, Warren Buffett is the second-richest man in the world with a total net worth in excess of $30 billion. Even more importantly, he is one of only a handful of names on that list to attain virtually his entire wealth via investments in the stock market.

(1.) THE EARLY YEARS

From an early age, Warren Buffett exhibited a strong penchant for business and the market. But Buffett's skills weren't pure instinctive talent; on his path to riches the Oracle was influenced by several prominent financiers of his day. Chief among them was Benjamin Graham, who gained fame as an investor in the wake of the 1929 crash, a time when most shunned stocks as investment vehicles. Graham was badly burned by the Great Crash, and the highly defensive investment philosophy he developed in the 1930s was molded by that adversity. In fact, many know him as the father of value investing; Graham looked for stocks that were trading well below their actual values and that offered what he called a "margin of safety."

The influence of Graham runs deep in Buffett's philosophy. Buffett read Graham's book, The Intelligent Investor, while studying at the University of Nebraska. Later in life he referred back to it often, indicating that it was, "By far the best work on investing ever written." Buffett also studied under Graham at Columbia Business School, earning the only A+ ever awarded to a student for that course. What's more, in the 1950s Buffett briefly worked for Graham's company.

But that's not to say that Buffett is just a carbon copy of Ben Graham. The father of value investing was focused mainly on balance sheet analysis--looking for companies with assets that far exceed their stock market values. He wasn't overly concerned with management or even a particular firm's business model. Instead, he focused primarily on what the company's assets were worth and how that figure compared to the firm's market value. Back in Graham's day, there were a number of companies that fit his strict investment criteria; the Crash of 1929 scared the investing public away from stocks for years. As a result, many stocks were trading at extremely low valuation levels. By the 1960s, however, stocks that met Graham's value criteria became far less common. By that point in time most businesses were valued at levels that, in addition to the value of their current assets, at least partially accounted for the firm's future growth prospects.

Buffett clearly modified his mentor's strict value approach as he began his investment career in 1956, forming the Buffett Partnerships mainly with investments from family and friends. For example, as my staff and I will discuss in greater detail below, Buffett studies management teams very carefully before investing. In addition, he is always firmly focused on what a company does and the value of its business model, not simply the value of its asset base. What has endured from his Graham mentorship, however, are the concepts of a margin of safety and intrinsic value.

Buffett's first partnerships were highly successful, as the Oracle of Omaha returned over +250% in his first five years as a manager compared to less than a +100% return from the Dow Industrials. Just ten years after he started the Buffett Partnerships, a still-young Oracle had amassed an investment portfolio of over $44 million; his initial investment of just $100 had ballooned in value to a stake worth nearly $7 million, an enormous sum in 1966.

By 1970, Warren Buffett had dissolved his partnerships, claiming he was unable to find any compelling values in the market. It was in that year that he took on the title of Chairman of Berkshire Hathaway (BRKa), which at the time was merely an odd hodge-podge of textile and financial businesses. Over the ensuing 34 years, Buffett has built the company into one of the most powerful financial conglomerates in the world, largely through his prowess in investing in high quality companies at bargain basement prices and holding on for long-term returns. Buffett's list of winning stock picks has grown quite long over that time period, and has included stocks like Coca-Cola (KO), Washington Post Co. (WPO), and, of course, insurance giant General Re.

My staff and I could simply present you with a chart of Berkshire Hathaway's share price performance going back to the 1970s. As you might guess, it would show tremendous growth in value over that time. However, that wouldn't be much in keeping with the Oracle's own investment philosophy. Instead, check out our chart of the growth in Berkshire's book value--theoretically the liquidation value of the company's assets--since he first became involved with the firm in 1965. Buffett includes this book value data in his famous annual Chairman's letter to Berkshire shareholders under the title "Berkshire's Corporate Performance." Amazingly, under Buffett's stewardship, the company has produced an average annualized rise in book value of over +22%, more than double what the S&P 500 offered over the same period. As you can see from our chart, those market-beating returns really add up over time.

(2.) BUFFETT'S PHILOSOPHY

Berkshire's performance is proof positive of the wisdom and value of Buffett's approach. Not surprisingly, dozens of books have been written on the subject, probing virtually every aspect of the Oracle's biography and all of his legendary investment decisions.

Of course, it's impossible to neatly distill all of his wisdom into any single book or article. However, we can study some of the key concepts and fundamental criteria that underpin Warren Buffett's approach to investing. Some of the concepts that follow are rather nebulous and subjective. Meanwhile, others are more numbers and statistics based. However, the bottom line is that a solid understanding of each can help improve any investor's performance. Let's review:

Easy-to-Understand Businesses
If you're a fan of retired Fidelity Magellan fund manager Peter Lynch, then you may remember his "buy what you know" concept. Buffett has long espoused a similar investing mantra. Essentially, Buffett believes in limiting your investments to companies with businesses that you can easily understand and analyze. After all, if you can't understand how a business makes money and what sort of markets it's involved in, then how can you possibly estimate its true value?

Even more importantly, it's easier to forecast future results for companies with straightforward and uncomplicated business models. Buffett always strives to look into the future when he invests, searching for businesses that he feels will still look solid 10 or 20 years down the road.

While most investors nowadays are attracted to the vast profit potential from technology stocks, Buffett's most successful investments have come from investments in more simple Old Economy businesses. As an example, take one of the Oracle's first purchases--See's Candy. See's operated a small chain of retail candy stores in the western part of the U.S. When Berkshire Hathaway bought the company in 1972 the stores were well known for high-quality candy products that commanded premium prices.

See's is a perfect example of an easy-to-understand Buffett business. The company boasts a profitable niche franchise and a lasting brand name. The candy business is also very simple--a few basic commodity raw materials like sugar and chocolate are manufactured into a variety of sweets, and these are then sold for a huge premium over their manufacturing costs. Demand for sweets is stable and unaffected by economic cycles, so it's fairly easy to predict what the firm's earnings picture will look like 10, 15 or 20 years in the future.

The other implication of the easy-to-understand mantra is, of course, Buffett's avoidance of the technology space. Buffett claims to have never fully understood all of the business and economic forces that are at work in this highly volatile sector. It's also more difficult to understand exactly what these companies do, why businesses need to buy their products and how demand changes over time. Buffett, therefore, has largely ignored technology stocks. Ironically, despite a long-term friendship with Microsoft chief Bill Gates, Buffett never bought that tech blue chip.

But don't assume that Buffett is just some investing dinosaur who invests in a bunch of readily understood consumer stocks. Berkshire's most important single industry group is insurance; the company owns GEICO and General Re and remains one of the world's largest insurers. You may think that insurance is a rather complicated business, but it still fits in well with Buffett's investing mantra.

Buffett has spent years studying the insurance industry, and he now understands it better than most other insurance executives. For example, when he was still 21 years old his interest in Ben Graham's teachings led him to visit GEICO, where Graham was chairman. Buffett traveled to Washington, D.C. and reportedly spent hours studying and discussing the company's books with its chief financial officer. More recently, Buffett knew General Re's management team and basic business long before he purchased the reinsurance giant in the 1990s.

If you're looking to put Peter Lynch's "easy-to-understand" criteria into practice in your own investing, then perhaps the best advice comes from Lynch himself. He's always said that if you can't explain a business and why you own its shares in just a few, coherent paragraphs, then you should sell it. We think Buffett would agree.

Low Debt Levels
Buffett looks very carefully at a company's debt burden before investing. Most of his big investing success stories have been in stocks like Coca-Cola, Washington Post and, more recently, Moody's (MCO). All of these names sported relatively low debts when Buffett invested.

Investors largely ignored debt burdens in the 1990s, focusing instead on growth metrics. And over the past few years, some analysts have discounted the importance of debt; extremely low interest rates have made corporate debt burdens relatively easy to service. However, debt remains an absolutely crucial item to watch and Buffett hasn't wavered in his focus on this metric. As Buffett himself so eloquently expressed in his 1987 letter to shareholders: "Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage."

Companies can generate cash to fund growth from two major sources: taking on debt or using internally generated cash in the form of retained earnings (profits made but not passed on to shareholders in the form of dividends). There is, of course, a third way--issuing more stock--but this hasn't been very common in recent years, at least not in the U.S. Buffett likes to see companies that fuel future growth through shareholder's equity, basically the sum of a company's net assets (total assets minus total liabilities) and retained earnings.

Companies that can grow using only their shareholder's equity are more or less internally financed. In other words, these firm's aren't dependant on money from banks, new shareholders or bondholders to stay in business. By contrast, companies with large debt loads are usually reliant on external financing--in most cases this means the capital markets--to keep growing and operating.

There are risks to these external financing sources. We all know that conditions in the capital markets can shift on a dime. Back in 1999, for example, a tech company could get showered with cash by simply listing its stock for public trading. By 2001, however, a bear market in technology stocks essentially closed that window. The same can be said for the bond market--interest rates rise and fall and bond investors' perception of risk sometimes changes overnight. Ultimately, these risks can result in a more volatile earnings stream.

When looking to measure a company's reliance on debt, it's important to examine the firm's debt-to-equity (D/E) ratio. D/E can be easily calculated simply by dividing a particular company's total debt load by its shareholder's equity. Both of these key figures are located on the balance sheet. There's no hard-and-fast rule for evaluating this metric, but as a broad average for non-financial companies, it's usually wise to look for firms with D/E ratios below 0.50 (50%).

Profitability and Return-on-Equity
A concept somewhat related to the D/E ratio is return on equity (ROE). In fact, if there's one single piece of financial data that's more often associated with Buffett than any other, it's ROE.

The calculation of ROE is simple and it's quoted on just about every financial website. Simply divide a company's net income--defined as total profits after interest, taxes and depreciation--by its shareholder's equity. This ratio measures how much profit a company produces relative to shareholders' investment in the firm. In other words, ROE answers one critical question: How much money does a firm make for its owners?

But don't assume that you can invest like Buffett simply by running a screen for stocks with very high ROEs. There are a couple of additional points to keep in mind. First, make sure to look for a stable or rising ROE over time. If a company has a particularly strong year, then its net income figure can be inflated, which can cause ROE to exceptionally strong. Such one or two-year blips have a tendency to fade quickly once the business environment becomes less favorable.

Many tech companies, for example, produced enormous ROEs in 2000 only to see reduced profitability (ROEs) in 2001 and 2002. Instead of looking at these figures in isolation, it's always important to examine ROE performance over a 5 or 10-year period. Check out our chart of the ROEs over time for Cisco Systems (CSCO) and Coca-Cola (KO). Coke's return on equity has hovered above 30% over the past five years and has never varied more than a percentage point or two over that entire period. By contrast, Cisco's ROE dipped into the red in 2001 and never exceeded 15% until this year. Coke certainly seems to be the more dependable company.

The second point to consider is the relationship between ROE and D/E. By taking on additional debts, companies can effectively lower the amount of shareholder's equity they need to stay in business. This has the tendency to inflate ROE. It's crucial, therefore, to look for companies that have high ROEs and low D/Es.

Managerial Expertise
In our brief biography of Buffett's career above, my staff and I pointed out one major difference between Buffett and his influential mentor, Ben Graham--Buffett wants to know as much as possible about the managerial team at any company he's considering purchasing and/or investing in.

The reason for this different approach is simple: Graham valued companies based exclusively on their break-up values--what they'd be worth if you purchased all the assets and sold those assets on the open market. By contrast, Buffett looks more at a company's value as an ongoing concern. Anyone can sell off assets, but it takes skill to manage a growing business. When Buffett makes an investment, he believes that he is buying a management team as well as the business itself.

In Buffett's case this has often meant getting to know a management team personally and garnering experience in business dealings with them. A great example is that of Clayton Homes, detailed in Berkshire's most recent (2003) Chairman's letter. In that letter Buffett explains how he became interested in and ultimately acquired Clayton Homes, a manufactured homebuilder.

In this case, Buffett first became aware of Clayton Homes in the 1990s when he bought the distressed junk-rated debt of Oakwood Homes, an investment that got wiped out when Oakwood declared bankruptcy. The problem with the manufactured homes industry, according to Buffett, is that overly generous consumer-lending practices often lead to a buildup of non-performing loans, and in some cases, eventually bankruptcy.

He was attracted to Clayton precisely because that company's management team was known in the industry to be very conservative on the consumer financing front, requiring larger down payments and shorter-term loans. Ultimately, Buffett says he contacted the company's CEO, Kevin Clayton, and was impressed with the way he described Clayton's risk management style. Buffett also attributes a great deal of his knowledge about the company to a biography he read on Clayton Home's founder, the father of CEO Kevin Clayton.

It's unlikely that the average investor will be able to precisely mimic Buffett's approach to understanding company management teams. However, there are still plenty of important lessons to learn from Buffett's approach. Chief among them is the fact that Buffett prefers companies with experienced management teams. In the case of Clayton, the company had been managed first by the father, then by son throughout both good economic times and bad. In addition, Buffett looks for companies with managerial teams that have a large economic stake in a business. Consider that Buffett himself has most of his economic wealth in Berkshire; most of the companies he buys sport managerial teams with similar financial ties to their business.

Intrinsic Value, Margin of Safety and Valuation
The three related concepts of intrinsic value, margin of safety and valuation form the core of what many consider to be value investing. Buffett's use of both intrinsic value and margin of safety were heavily influenced by the teachings of mentor Benjamin Graham.

Intrinsic value is defined as a particular firm's true, inherent value. Many investors take completely different approaches when attempting to estimate a firm's intrinsic value. As a result, you'll often see wildly different assessments of a particular firm's true value. However, most estimates incorporate many of the same variables, including the value of a firm's real assets, its current and future earnings, and the value of intangibles like brand names. Graham focused mainly on a company's assets and book value--basically the actual numbers that can be found on the balance sheet.

Buffett, however, tends to lend more credence to intangibles and potential growth in a business. Buffett's analysis of intrinsic value focuses on key fundamentals like earnings, revenues, assets, cash flow (see below) and projected growth. In other words, Buffett looks to a company's earnings power over the next 10 years or so. What's more, by focusing on companies with high ROEs, low D/E and solid management teams, he finds stocks that have stable growth prospects.

Margin of safety is an important concept popularized by Graham. In essence, the idea is to give yourself room to make mistakes when assessing intrinsic value. After all, if you overestimate the value of a business, then you're likely to overpay for its stock. However, if you require a large margin of safety before making any investment, then you'll reduce your chances of making a poor decision.

Graham would not invest in a stock unless it was trading at a minimum of a 25% discount to what he believed was the true value of the firm--in other words, he required a 25% margin of safety. Graham's crash-influenced defensiveness is obvious here, he wanted to make sure that if his intrinsic value estimate was incorrect, there was still room for profit. Buffett, like Graham, looks for companies that are trading at around a 25% discount to his calculation of their intrinsic value.

Margin of safety goes back to Buffett's strategy of only investing in companies that offer relatively low-risk returns on his investment. In his 2003 letter to shareholders, Buffett says: "...our default position is US Treasuries...Charlie [Munger] and I detest taking even small risks unless we feel we are being adequately compensated for doing so." The adequate compensation to which Buffett refers is his margin of safety.

When examining a firm's value, investors have a variety of tools at their disposal. The most commonly used valuation metric is the price-to-earnings (P/E) ratio, which can be calculated by simply dividing a company's price per share by its net income per share. This metric isn't without fault; one of the biggest complaints against P/E ratios is that most companies use creative accounting to manipulate their earnings numbers. That introduces a great deal of bias in P/E ratios. As a result, my staff and I usually recommend looking at P/E ratios in combination with other valuation metrics, such as price-to-free-cash-flow P/FCF (described below). By double-checking valuation in this way, it's possible to eliminate biases caused by "dirty" earnings numbers.

Another big problem with a plain vanilla P/E calculation is that it doesn't take into account a company's growth rate. Therefore, a comparison of P/Es between different companies in different industries is like comparing apples to oranges.

The so-called PEG ratio--a very useful valuation measure that's often associated with Buffett--can help. The PEG, or price/earnings-to-growth ratio, is calculated by dividing a stock's P/E by an estimate of its long-term future growth rate. As a rule of thumb, stocks that sport a PEG of under 1.0 tend to represent good value. Of course, it's important to remember that the long-term growth rate used as part of the PEG ratio is an estimate, not a cold, hard statistic. As such, variations in a firm's estimated growth rate can have an enormous impact on a given stock's PEG ratio. Because of this, it's critical to look at past earnings growth and the stability of that growth over time to determine if a firm's growth estimates seem reasonable.

Along these same lines, Buffett normally shuns new initial public offerings (IPOs) and companies that have been in business for less than 10 years. One reason is that it's hard to estimate growth and future prospects for such firms. This is also where Buffett's margin of safety comes into play--it's a good idea to be conservative and underestimate future, uncertain growth rates.

Economic Moats
Think of a medieval castle surrounded by a moat full of water. The wider the moat, the more difficult it is for invaders to successfully attack and conquer the castle. So, how does this concept apply to the financial markets? It's simple--companies that have wide moats are better insulated from competitive threats and fluctuations in the business cycle.

Consider some of Buffett's classic holdings like Coke, Gillette (G) and American Express (AXP). Coke and Gillette make staple products, goods that most people use each and every day. If the economy goes into recession, then are you really going to cut back on your consumption of Coca-Cola and razors? For most Americans, the answer would be no--there are far bigger-ticket, less essential spending items that would get cut first.

Both Coke and Gillette have wide economic moats. They're sheltered from recession, slower growth and rising interest rates because demand for these products is quite stable. Better yet, Coke and Gillette both have established brand names and franchises. Consumer studies have shown that the average consumer will reach for his/her favorite brand of shaving cream and soda time and again. The same consumers will also pay a premium price for their favored brand. This is a big advantage (economic moat) for these companies--it allows them to maintain fatter margins than generic competitors and still maintain growth throughout both good times and bad.

There's also another type of moat that's important for Buffett--the competitive moat. Before investing in any stock, you should always ask yourself how easy it would be for another startup company to come along and replicate your stock's business model. If it would be extremely difficult to do so, then chances are excellent that your stock boasts a wide competitive moat. Coke and Gillette, for example, are insulated from competitive threats thanks to their wildly popular brand names. Although a competitor could certainly start a rival soda company, the firm would have incredible difficulty creating a popular brand name and brand image all over the world. Simply put, Gillette and Coke are not commodity companies.

American Express also has wide competitive and economic moats. For starters, the firm boasts an extensive charge card network and millions of customers around the world. In addition, the company, like Coke and Gillette, has garnered a premium brand image by building up its cardmember services offerings. Consider that even though American Express charges merchants about double what Visa, Mastercard and Discover do, most businesses of any size accept AMEX. Consumers, for their part, are willing to pay an annual membership fee to get access to premium services like emergency cash, travel insurance and flight guarantees.

There are a few important metrics to watch when analyzing economic moats. First up, as we reviewed above, a stable or growing ROE over a long period of time is a good sign that a company is reliably profitable. Another metric that Buffett watches carefully is profit margins. More specifically, my staff and I normally look at each firm's operating profit margin, defined as the ratio of operating profits to revenues. In other words, how much profit is a company generating out of each dollar in sales? Watch operating margins over time; margins, like ROE, should remain steady or grow even during soft economic environments. As a general rule of thumb, companies with profit margins under 10% should generally be avoided--margins that thin suggest a lack of pricing power and a vulnerability to any downturn in business.

Free Cash Flow and Owner's Earnings
Warren Buffet also tends to shun companies in capital-intensive businesses--firms that need to make frequent, large capital expenditures (capex), such as purchases or upgrades to physical assets--to keep growing. The reason is simple: large capital expenditures drain cash from a business and lower the return available for shareholders. The excess return that remains for shareholders (owners) is the ultimate determinant of a company's true value.

Free Cash Flow (FCF) is the key metric to watch. To calculate free cash flow, simply subtract capital expenditures from a firm's operating cash flow. Because capital expenditures must be spent to fund future growth, this cash isn't available to shareholders. Free cash flow measures the cash available to shareholders after a company has paid all of its bills in full.

One way to look at cash flow is to examine a firm's free cash flow yield. Like dividend yield, this is calculated by dividing free cash flow per share by a firm's share price. This measures the annual return in cash terms an investor receives from a company. A firm with a free cash flow yield of 10%, for example, generates 10% of its total market value in cash each year. That cash, in turn, can be used to pay dividends or complete share buybacks--items that add to shareholder returns. When making any investment, Warren Buffett always looks for companies that have generated stable, above-average free cash flows for five years or more.

Stay tuned for Part 2 of this article on Friday, September 3.