Wednesday, July 8, 2009

Myths about Warren Buffett

Warren Buffett is the richest investor in the world. The student of the father of value investing Ben Graham, learned how to invest money in the Graham-Newman Corp. partnership in the early 1950s. After it was closed, Buffett formed his own investment management partnership. In it, he utilized several value investment strategies, which allowed him to significantly outperform the S&P 500 for over a decade. In the early days of his partnership it was pretty easy to uncover value investment opportunities, since the partnership was small enough to deal where few investment advisers and mutual funds had the insight to operate.

In 1969, Warren Buffett closed his partnership, citing the fact that the market was overpriced and that bargains fitting the strict value investing principles that Graham taught him were tough to uncover.

At the same time he concentrated his actions on a small textile operation called Berkshire Hathaway, which is his flagship holding company. His success at Berkshire is astounding, but it is not merely due to value investing strategy, as is commonly known. Had Buffett not branched out of strict value investing principles that Graham taught him; Berkshire Hathaway would have remained a relatively small conglomerate. Buffett did branch out into other strategies however. His insurance operations are similar to selling naked puts or calls – he generates enough premium which in most cases doesn’t have to be paid out for many years to come, giving him a low cost source of financing. His recent deal to sell long term puts (LEAPs) on four major stock indices is another example of branching out.

Buffett also essentially shorted the US dollar. In 2002, Buffett entered in $11 billion worth of forward contracts to deliver U.S. dollars against other currencies. By April 2006, his total gain on these contracts was over $2 billion. In 2005 he reduced his exposure to the currency futures he was holding. His play on the weakening dollar is by purchasing solid businesses which derive a portion of their earnings from outside the US.

Most people I talk to also seem to believe that Buffett owns a concentrated portfolio of 10-15 positions, which allows him to allocate the most funds in his best ideas. A recent look at Berkshire Hathaway’s stock portfolio revealed 40 stock positions from a variety of industries such as consumer staples, utilities, financials, retailers, energy and many other sectors. In addition to that Berkshire Hathaway owns a variety of businesses ranging from insurance ( Geico and General RE) , Utilities ( Mid american), Apparel, Building Products, Flight Services, Retail, Financial, and Conglomerates such as the recently acquired Marmon Holdings.

Another example is his investments in Gillette, acquired by Procter and Gamble(PG) ; Coca Cola (KO) and Johnson & Johnson (JNJ). Buffett purchases businesses with wide moats, which he believes have strong growth potential, that would lift earnings and distributable cash flows. His yield on cost on his 1988-1994 $1.298 billion investment in Coca Cola (KO) is a staggering 25.20%. His average purchase price comes out to $6.49/share, whereas the annual dividend is $1.76/share after the most recent dividend increase.

Another interesting investment is in See’s Candies, which he purchased for $25 million in 1972, at a time when its pre-tax earnings were $5 million on $30 million of sales. The confectionary maker in a slow growth industry currently generates enough cash flow, which is then redirected to other business opportunities. In fact over the past 35 years, the capital needs for the company have risen from $8 million to $40 million annually, while it has returned $1.35 billion worth of pre-tax earnings to be allocated somewhere else.

Yet another myth about Buffett is that he doesn’t like dividends. The contrary is true – from his early days of buying farmland and operating a newspaper route to buying pinball machines Buffett has been particularly interested in the distributions from his business. His investments in See’s Candies and other businesses like Coca Cola (KO) and Johnson & Johnson (JNJ) throw off enough cash in the form of dividends to Berkshire Hathaway that he then allocates appropriately. The same is true for many dividend investors, which are primarily interested in purchasing stable wide moat businesses, that have the ability to grow earnings. That way these companies can afford to consistently raise distributions to shareholders. Dividend investors then allocate their dividends received in the best manner suitable – either by purchasing more stock or spending it on their own needs.

Another myth about Warren Buffett is that he never sells. In 1998 he sold his position in McDonald’s (MCD) for a tidy profit. In his 1998 Letter to Shareholders, Buffett called this move “a very big mistake”. While McDonald’s stock closed 1998 at $38 it did fall to as lot as $12 at the bottom of the 2000-2003 bear market, before staging a massive rally during the 2003-2007-bull market. The stock is one of the few, which have not seen their shares fall of a cliff in the recent bear market.

The future of Berkshire Hathaway is really what gives nightmares to its investors. Due to its sheer size, it has to concentrate only on opportunities in the billions of dollars. In “THE SUPERINVESTORS OF GRAHAM-AND-DODDSVILLE” he explained that “if you ever get so you're managing two trillion dollars, and that happens to be the amount of the total equity valuation in the economy, don't think that you'll do better than average”

It would be impracticable to concentrate on hundreds of smaller deals, which could potentially generate higher returns. One idea that Berkshire could implement is to franchise Buffett Partnership’s business model to hundreds of small value investors with $1 million in seed capital, and watch them become the next Buffett. This could bring in new life to Berkshire.

Buffett seems to like companies, which generate enough in royalties due to their high moats for many years to come. Such competitive advantages that allow them to spend a considerable amount of funds upfront on research and development to create a unique product and then sell it for many years in the future is closely resembling the idea of passive income that many investors are constantly seeking out. Such companies which generate “royalty” type of revenues includes See’s Candies, Microsoft (MSFT), Coca Cola (KO), and pharmaceuticals companies such as Pfizer (PFE) or Eli Lilly (LLY).

Below I have summarized some interesting materials I found about Buffett:

Buffett Partnership Letters

Berkshire Hathaway Shareholder Letters

Buffett’s E-mail correspondence about Microsoft


This article was featured in the Carnival of Personal Finance: New Zealand Edition!

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- Dividend Aristocrats Strike Back
- Warren Buffett – The Ultimate Dividend Investor
- Coca Cola (KO) Dividend Stock Analysis
- Warren Buffett’s Berkshire Hathaway Portfolio Changes for Q1 2009.

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