In the league of Benjamin Franklin, Ernest Hemingway, and Henry Ford, is Warren Buffett, says Prem C. Jain. “Their ideas are simple to understand, but their successes are difficult to duplicate. However, geniuses abide by certain principles that we can learn from,” adds Jain in ‘Buffett Beyond Value’ ( >www.wiley.com ). The book brings together investment wisdom of the Oracle of Omaha from Berkshire Hathaway annual reports, Buffett’s letters to shareholders and partners, and other writings.
Develop a mind-set to win
The first principle of Buffett is to develop a mind-set to win, says the author. “You play a game because it’s fun and even exhilarating when you win. You will win often when you play to your strengths. In the stock market game, this means staying within your circle of competence.”
The dumbest reason in the world to buy a stock is because it is going up, reads a quote of Buffett in a chapter on investment psychology. “When people do not understand a company well, they follow the crowd: They chase the winners and dump the losers indiscriminately,” rues Jain. “Because of this herd mentality, individual stocks – and the entire market – may go up or down dramatically. Herding stems from greed or fear.”
How to find out if you have the herding instinct? Just check if you feel like buying a stock when its price has recently gone up or when the market has gone up. If you do so without evaluating the company, you are probably herding, guides Jain. In the opposite, you are probably not herding if you compute a stock’s intrinsic value before you make a buy or sell decision, he distinguishes.
Stick with value investing
The second principle is to stick with value investing, after examining historical records, price-to-earnings (P/E) ratios, and other financial measures. Value investing is like buying Christmas cards in January, at about half the price of the same cards a month earlier, instructs Jain. “For value investing in the stock market, you buy when prices are low relative to fundamentals (e.g. earnings and book value), and then wait for prices to move up.”
Since good deals may not be available every day, an investor must be patient and wait for such opportunities to arrive, the author advises. “You need patience to wait for a truly outstanding value opportunity, and you need even more patience after you purchase a stock. It often takes time for price to reflect value.”
Also, good opportunities in the stock markets do not announce their arrival, he reminds. “Nor can you always anticipate the industry or geographic location in which opportunities might arise. Furthermore, you will never know for sure that an opportunity is staring at you.”
Growth plus value
The third principle calls for a combination of growth investing and value investing, because management with integrity and competence is key to growth. In this context, the book speaks of one of Buffett’s acquisition criteria, which is deceptively simple but very insightful: He acquires a company only if the current management comes with the acquisition, unlike as in most acquisitions where the acquirers replace the incumbent management with a new team of their own.
The logic, as Jain decodes, is that if the acquired business was successful under the existing managers, they should not be replaced. Also, since the seller gets to keep the company under his control, he may be willing to take a lower price.
More importantly, this reduces the likelihood of Buffett ending up with dishonest managers who could have manipulated earnings in the past to get a good price from selling the company. “Most hidden problems (e.g. earnings management or off-balance- sheet debt) are likely to surface within a few years. No one would want to manage a company knowing that it has such a ticking time bomb.”
Maintain low risk
The fourth principle is to maintain low risk, with low debt level. From the shareholders’ perspective, return on equity (ROE) is usually the best yardstick, as it isolates the returns that belong to the shareholders from the returns to the enterprise as a whole, advises Jain.
A companion ratio that he discusses is ROA (return on assets), a measure of performance that is independent of financing. “A comparison of ROA to ROE tells us the extent to which the company may be using implicit or explicit leverage. Many of the items in the liabilities section of the balance sheet are non- interest-bearing, so an examination of interest expense or the balance sheet analysis would not tell you the extent of financial leverage.”
Accounting knowledge
When studying ratios, pay attention to management quality, cautions the author. He also cites Buffett’s advice to investors on the need for developing a good knowledge of accounting. “Remember that you are a consumer and not a preparer of financial information. Act like a detective trying to understand the company’s business from reading financial statements… As a reader of financial statements, you could have fun discovering behind-the-curtain stories.”
Accountants make many assumptions, Jain notes. They are supposed to be conservative, reads another aspect. Watch out, however, because accountants can in many cases be aggressive!
A regular dividend payment by itself is not a strong enough variable to characterise a company as a good investment, warns a nugget of insight in the corporate governance section. “When a company paying regular dividends also raises funds in the financial markets and the balance sheet is not strong, you should be careful about investing in its stock. Dividend payment is just one possible use of free cash flows. What is most important is your comfort level with a company’s usage of its free cash flows.”
Act rationally
The fifth principle of Buffett is to act rationally. And knowledge is the best antidote to irrationality, underlines Jain. Know the company’s business, and project what the company will look like in ten years, he urges.
To those who advocate diversification as a way to reduce risks, Philip Fisher’s counsel should be apt. “Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all.”
Buying a share without having sufficient knowledge of the company may be even more dangerous than having inadequate diversification, Fisher adds. Relevant, again, is the message of Peter Lynch quoted in the book, thus: “It’s best to own as many stocks as there are situations in which: (a) you’ve got an edge; and (b) you’ve uncovered an exciting prospect that passes all the tests of research. Maybe that’s a single stock, or maybe it’s a dozen stocks.” Companies, which are supposed to act more rationally than individual investors, can be foolish, especially when making acquisitions, as some of the examples given in the book show.
Most people are unlikely to invest efficiently in a large number of stocks from several industries, bemoans Jain. “In such cases, diversification can become ‘diworsification,’ a situation in which diversification can hurt your returns, rather than protect them.” Imperative read for value-seeking investors.
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