My Notes
Be willing to be inactive. Why rush to act on sub-par opportunities?
Bet big on your best ideas. You are more likely to get a few key decisions right rather than force yourself to make many correct choices. You will see better results and avoid more stupidity with this philosophy.
Investment mistakes:
- The price you paid
- The management you joined
- The future economics of the business.
Hagstrom’s Tenets of the Warren Buffet Way
Business tenets
Is the business simple and understandable?
- Stay within your circle of competence. Your ability to make wise decisions is limited when you lack understanding of what’s really going on. The size of your circle of competence is less important than how well you define the parameters of what you do and do not know.
Does the business have a consistent operating history?
- Major business changes invite major business errors.
- “Charlie and I have not learned how to solve difficult business problems. What we have learned to do is avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.” In other words, avoid businesses trying to solve too difficult of problems.
Does the business have favorable long-term prospects?
- Great businesses are wanted, have no close substitutes, and no regulation. These traits build moats that provide long term competitive advantages.
Management tenets
Is the management rational?
- Management must allocate excess capital in three ways: invest it and earn above-average returns, give it back to shareholders through dividends, or buy back shares. The right choice is whichever creates the highest returns for shareholders.
Is the management candid with its shareholders?
- Managers must discuss failure openly and honestly communicate their companies performance.
Does management resist the institutional imperative?
- Mindless imitation of peers produces subpar results, but managers nonetheless succumb to what they think they should do rather than what is rational.
- Organizations fall victim to the institutional imperative when they resist changes in direction, fall into hyperactive tendencies with unnecessary acquisitions and projects, company members satiate rather than inform managers, and thoughtless imitation of peers.
Financial Tenets
- Buffet uses the ratio of operating earnings to shareholder equity as a measure of company success. This ratio is useful only when shareholder equity is valued at cost and not current market value and capital gains and losses are not included in operating earnings.
- Focus on return on equity, not earnings per share
Calculate “owner earnings”
- Cash flow doesn’t incorporate the necessary capital expenditures many businesses need, so Buffet uses owner earnings: Net income plus depreciation, depletion, amortization, less the amount of capital expenditures or additional necessary working capital that might be needed.
Look for companies with high profit margins
- Companies with low-cost operations will continue to find ways to cut expenses.
- For every dollar retained, make sure the company has created at least one dollar in market value
Market Tenets
What is the value of the business?
- “The value of a business is the net cash flow expected to occur over the life of the business discounted at an appropriate interest rate”
- This only works if you have the right variables. Cash flow is tough to predict unless you have an understandable business, and Buffet uses the long-term government bond rate for his discount rate.
Can the business be purchased at a significant discount to its value?
- Buffet uses the margin of safety principle to protect downsides and provide opportunities for excellent returns. A business with an intrinsic value only slightly above the per-share price isn’t worth buying. A company that can be bought at a 25% discount to intrinsic value can still provide adequate returns even if value declines by 15%.