1962, a 32-year-old Warren Buffett acquired a textile manufacturer, Berkshire Hathaway (NYSE: BRK-B).Buffett took total control of the company in 1965 and replaced the company's management team.
Buffett wasn't interested in the textile business itself, but was instead interested in the firm's cash. While the business wasn't growing, Berkshire generated copious free cash flow and had plants, equipment and land that could be liquidated to provide even more cash.
With this in mind, Buffett dissolved his investment partnership and began instead to invest Berkshire's excess cash flows, offering his investors a stake in Berkshire in lieu of their previous fund holdings.
Investors who took that deal were amply rewarded. Buffett's returns have been nothing short of legendary, averaging nearly +22% annually since he took over Berkshire's reins in 1965.
$10,000 invested in Berkshire in the 1960s would be worth more than $36 million today against less than $700,000 for the same sum invested in the S&P 500. That's more than a +361,000% gain.
Amazingly, out of the more than 40 years Buffett has been at the helm of Berkshire, there has only been one year in which Berkshire's book value actually fell. And Berkshire stock has only underperformed the S&P 500 six times in that timeframe.
Buffett's long track record of success is unprecedented -- according to Forbes, Warren Buffett is among the richest men in the world with a total net worth above $50 billion. But what's even more unique is that he is one of only a handful of names on that list to attain virtually his entire wealth by investing in the stock market.
Berkshire's performance is proof 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 life and all of his legendary investment decisions.
(FIRST) Buffett's Point of View
-- Easy-to-Understand Businesses
Buffett believes in limiting your investments to companies with businesses that can be easily understood and analyzed. After all, if you can't understand how a business makes money, then how can you possibly gauge its financial performance or estimate its true value?. It's easier to forecast future results for companies with straightforward and uncomplicated business models. Buffett likes to look into the future when he invests, searching for businesses that he feels will still look solid at least 10 or 20 years down the road. If you can't fully explain a business and why you should own its shares in just a few, coherent paragraphs, then you should walk away.
-- Low Debt Levels
His success stories like Coca-Cola (NYSE: KO), The Washington Post Co. (NYSE: WPO), Moody's (NYSE: MCO), etc, it is obvious that Buffett carefully examines a company's balance sheet, and prefers to invest in those with relatively modest debt burdens. During the 1990s, investors ignored debt levels and focused instead on growth metrics. However, to his credit Buffett has never wavered in his focus on debt. In his 1987 letter to shareholders, Buffett eloquently noted that: "Good business or investment decisions will eventually produce quite satisfactory economic results with no aid from leverage." In the years since, adhering to that policy has kept Berkshire shareholders out of trouble. When it comes to funding future growth, Buffett prefers companies that can meet their requirements through internally generated cash, as opposed to raising capital by taking on debt or issuing more stock. Companies that can grow using only their existing cash flows are more or less internally financed. In other words, these firm's aren't dependant on securing loans 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. However, by 2001 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. Of course, a credit downgrade can make it much more costly to secure financing, and higher interest payments tend to eat into profits. When measuring a company's reliance on debt, it's usually helpful to begin by examining its debt-to-equity (D/E) ratio. D/E can be easily calculated 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%).
-- High Profitability and Return-on-Equity
A piece of financial associated with Buffett is return-on-equity (ROE). The calculation of ROE is relatively simple, and can be found on all financial websites. Simply divide a company's net income -- defined as total profits after interest, taxes, and depreciation -- by its shareholder equity. This ratio measures how much profit a company produces relative to shareholders' investment in the firm. Earnings growth always comes at a price. That's where ROE comes in. This figure tells us how efficiently a company is using the capital. Companies showing ROE of 15% or higher must be picked. ROE must be checked to know if has been falling, rising, or stable over time. Also, if a company has a particularly strong year, then its net income figure can be inflated, which can cause ROE to be exceptionally strong. Such one or two-year blips have a tendency to fade quickly once the business environment becomes less favorable. Therefore, it's always important to examine ROE performance over a five or ten-year period. The second point to consider is the relationship between ROE and D/E. By taking on additional debt, companies can effectively lower the amount of shareholder's equity they need to stay in business. By definition, this tends to inflate ROE. Therefore, it's crucial to look for companies that have a high ROE and low D/E.
-- Proven Managerial Expertise
Not all of Buffett's investing criteria is objective. Buffett seeks out firms with highly competent management teams. When Buffett makes an investment, he believes that he is buying a management team, as well as the business itself. In fact, when Berkshire makes an acquisition, the existing management team usually remains in place after the deal is completed. Typically, this has often meant getting to know a management team on a personal level. A great example of that is Clayton Homes, as detailed in Berkshire's 2003 annual report. In a letter addressed to Berkshire's shareholders, Buffett explained how he became interested in and ultimately acquired Clayton Homes, a manufactured home builder. Buffett 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 home industry, according to Buffett, is that overly generous consumer-lending practices often lead to a buildup of non-performing loans, and in severe cases, high default rates can eventually lead to bankruptcy. Buffett was first attracted to Clayton because the company's management team was well known in the industry for its conservative lending practices, which included larger down payment requirements and shorter-term loans. Ultimately, he contacted the company's CEO, Kevin Clayton, and was impressed with the way he described the company's risk-management style. Buffett also attributed a great deal of his knowledge about the company to a biography he read on Clayton Home's founder, Jim Clayton, the father of the CEO. Buffett prefers companies with capable, experienced, and trustworthy management teams -- particularly if they have an economic stake in the business. A company is only as strong as its leaders, so ask yourself these questions before investing: Do leaders candidly admit mistakes? Are the incentives of a company's managers aligned with the interests of shareholders? Does the stock have relatively high insider ownership? Has the firm made rational decisions with its retained earnings? Is management committed to delivering long-term shareholder value, or does it destroy value by employing tactics designed to meet arbitrary short-term earnings targets and appease Wall Street analysts?. Financial results can change overnight, so it pays to also evaluate the leaders responsible for delivering those numbers.
-- Attractive Valuation and Measurable Margin of Safety
"The more vulnerable the business is...the larger margin of safety you'd need." W. Buffett. We all invest with one goal in mind: to buy a stock at one price, and then later sell it at a higher price. Therefore, the price we pay should always be the first and most important consideration. The concepts of intrinsic value and margin of safety form the core of what is considered value investing. Buffett's use of both intrinsic value and margin of safety were heavily influenced by the teachings of mentor Benjamin Graham. As opposed to P/E ratios and other similar valuation tools, which only tell us how expensive one stock is relative to another stock, intrinsic value attempts to capture the true worth of a company, and by extension, its share price. Of course, investors often take different approaches when attempting to estimate a firm's intrinsic value. As a result, you'll often see wildly different assessments of what a particular stock is worth. 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 current assets and book value -- 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, and his analysis of intrinsic value focuses on key fundamentals like revenues, assets, cash flow (see below), and projected growth. In other words, Buffett believes that a company's valuation is often driven by its long-term earnings power. However, nobody can precisely project a company's future earnings exactly, so it is important to leave some room for error -- or a margin of safety. 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 the chances of making a poor decision. For example, paying $45 for a stock with an intrinsic value of $50 might be okay if everything goes according to plan -- but what if the company's growth rates began to miss the mark? By refusing to pay any more than say, $30 for that same stock, you would have substantial room for future downward adjustments to intrinsic value. In other words, if the company's results stray off target or some unexpected problem pops up, dropping the intrinsic value to $40, then the stock would still have $10 of upside potential. Graham would not invest in a stock unless it was trading at a minimum 25% margin of safety. Likewise, Buffett looks for companies that are trading at deep discounts to his calculation of their intrinsic value.
-- Sustainable Economic Advantages
"The key to investing is ... determining the competitive advantage of any given company and, above all, the durability of that advantage." W. Buffett. It has long been one of the most fundamental axioms of basic economics: success invites competition. Regardless of the industry, any company that finds a way to earn outsized profits will sooner or later attract competition. While no company is immune, some are less susceptible to the threat of competition than others. Those with well-developed economic advantages in place are much more likely to withstand an attack from competitors. 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. Because Buffett is always thinking down the road, this concept is central to his investment philosophy. Some economic moats are easily spotted. For example, stringent SEC regulations and oversight have long thwarted new companies trying to enter the credit ratings business, and that barrier to entry has dug a wide economic moat for established players like Moody's (NYSE: MCO). A strong brand name would be another example. Coca-Cola (NYSE: KO) is one of the most widely recognized names in the world, and that valuable brand gives the firm significant pricing power, as millions of consumers are willing to pay premium prices for Coca-Cola beverages. Not surprisingly, both Moody's and Coca-Cola are long-time Berkshire holdings. However, there are many other competitive advantages that are not easily recognized. For instance, a powerful retailer might have tremendous bargaining power over suppliers, and thus be able to negotiate favorable purchasing terms -- a firm like Wal-Mart (NYSE: WMT) springs to mind here. The network effect is another intangible, but very real competitive advantage. Just think of online auction giant eBay (Nasdaq: EBAY). Millions use eBay to sell items because of the large number of potential buyers the site reaches. Meanwhile, millions of buyers shop on eBay because of the high number of sellers offering a variety of products. As the site's membership continues to grow, the benefit to both buyers and sellers grows as well -- further strengthening the company's position in the market.
-- Consistent Free Cash Flow and Owner Earnings.
"Calculate owner earnings to get a true reflection of value." W. Buffett. Due to the nature of accrual accounting, a company's net income often bears little resemblance to its true net cash profits in any given period. Therefore, it is usually a good idea to also keep track of free cash flow (FCF) -- or operating cash flows less capital expenditures. Free cash flow measures the cash available to shareholders after a company has paid all of its bills in full. Buffett relies heavily on a similar metric that he dubs "owner earnings." One way to gauge a firm's cash flow production is to examine its free cash flow yield. This is calculated by dividing free cash flow by market capitalization, or the inverse of the Price/FCF ratio. 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 fund share buybacks -- items that enhance shareholder returns. Buffett always looks for companies that have a proven ability to generate healthy, consistent free cash flows over the long-haul.
(SECOND) How You Can Profit from Buffett's Teachings
The most obvious method is to buy shares directly in Berkshire Hathaway itself. Berkshire is an unusual entity. Since Buffett took effective control of the holding company in 1965, he has never split the stock or declared a dividend, believing that any excess earnings should be held for reinvestment. The other thing to remember about Berkshire is that the investment side of the firm's business is only part of the story. Berkshire is also one of the world's largest insurance companies. Keep in mind that insurance firms make money in two ways: underwriting income and investment income.
On the underwriting side, Berkshire is very profitable. The company's GEICO subsidiary focuses on insuring low-risk drivers at favorable rates. That's a solid niche business to be in -- it's easier to model the claim payouts necessary to cover safer drivers. Meanwhile, the company's reinsurance unit (reinsurance is the business of insuring other insurance companies as a means to spread risk) is one of the largest and most profitable players in the industry.
While underwriting profits are certainly desirable, Berkshire's insurance operations come with an added benefit -- they feed Buffett a large pile of cash to invest. Specifically, after the firm's insurance units take in premiums, Buffett is then free to invest these funds until they have to be paid out as claims. This cash, called the float, forms the core of what Buffett invests for Berkshire. Of course, all insurance companies invest their float in stocks and bonds. However, when it comes to Berkshire, you're buying the investment savvy of Warren Buffett as part of the mix.
There's also another unique way for individual investors to invest directly in Buffett's philosophy, the Wisdom Fund (WSDVX). This mutual fund's stated goal is to mimic the investments made by Berkshire Hathaway, and its top holdings include Coca-Cola, Wells Fargo, American Express and Johnson & Johnson -- mirroring Buffett's long-time core positions. Keep in mind, though, that the fund's returns may differ from those of Berkshire, as Buffett also has stakes in many private businesses, as well as foreign securities. Nevertheless, the fund is still a quick and easy way to follow in Buffett's footsteps.
Applying Buffett's Teachings
Investing in Berkshire, the Wisdom Fund, or just picking up stocks that are traditional Buffett favorites are all good ways to cash in on Buffett's timeless value philosophy. However, the best idea of all is to learn from Buffett's investments and try to adapt his techniques to your own investment strategy.
Regardless of your particular investment strategy, Buffett would advise a long-term, buy-and-hold perspective. He also believes that diversification is for beginners only, as more experienced investors are better off sticking to their best ideas than spreading their assets too thin. Look for mature, well-run companies with good cash flow visibility, high returns on capital and sustainable competitive advantages. And when you find them, resist the urge to get caught up in day-to-day fluctuations.
With all this in mind, we spent countless hours scouring the market for a few stocks that we believe fit Buffett's criteria. None of these picks are currently in Berkshire's portfolio. However, for a variety of reasons we believe they best exemplify the spirit of Buffett's philosophy.
Three quality Buffett-like investments . . .
Automatic Data Processing (NYSE: ADP)
ADP is one of the world's largest payroll processors, with an established base of 585,000 clients representing roughly 35 million workers around the globe. The firm also provides a full suite of related business services, ranging from background screening to benefits administration, as well as inventory management systems and support for more than 25,000 automobile dealers. Every day, millions of people receive their wages, either via paycheck or direct deposit, and few of us ever stop to think about how that money was transferred from an employers' account to our own. However, the process can be quite complex, particularly for larger organizations. Time sheets may need to be validated, payroll taxes have to be calculated, and deductions for health care premiums and retirement account contributions must be withheld. Determining the final total and making sure that employees are paid promptly and accurately can be an expensive and time-consuming undertaking. That's where ADP comes in. As a trusted leader in the field, ADP handles these outsourced operations for thousands of employers around the world -- reducing expenses, eliminating bookkeeping headaches, and giving companies more time to do whatever it is that they do best. Few rivals can match the comprehensive platform ADP has built -- the firm now distributes paychecks to one out of every six private sector workers in the U.S. And once those companies have been freed of the payroll burden, many of them turn to ADP for other services, such as employee background screens, workers compensation coverage, and 401(k) plans -- everything from "hire to retire." Integrating payroll processing with retirement plans and other human resources functions can yield considerable cost savings, and ADP has become proficient at cross-selling new products and services to existing clients. At the same time, a 90% customer retention rate is a testament to the firm's expertise, efficiency, and commitment to customer service. With a well-respected brand name and a global platform that would be incredibly difficult and expensive to replicate, ADP's core operations are protected by a wide economic moat. As is often the case, this moat is invisible to the eye, but its impact is reflected in the firm's lofty operating margins, which currently stand at 20% -- well above the industry average. Though unemployment ebbs and flows, favorable demographics (population growth, longer life expectancy, etc) tend to expand the overall size of the labor pool over time. ADP has benefited nicely from this trend, at one point racking up 41 consecutive years of double-digit earnings growth. Though that impressive streak came to an end when the events of September 11th, 2001 took a heavy toll on the economy, ADP is still a model of consistency, and analysts expect the firm to deliver healthy profit growth of +14% per year over the next five years.
Diageo (NYSE: DEO)
Brewing king Anheuser-Busch (NYSE: BUD) is currently one of Buffett's top holdings, and it's not a stretch to assume that he might also find many favorable traits in one of the firm's rivals from across the pond -- the world's largest liquor distributor, Diageo. Diageo produces, packages, and distributes a wide range of premium products in more than 180 markets around the world. Beer remains on top as the nation's drink of choice. However, the wine and spirits groups have closed the gap markedly in recent years, and they now sit close behind. Around the country, many drinkers, particularly the trend-conscious younger crowd, have been increasingly ordering a glass of wine or a splashy cocktail over a bottle of beer. And while per-capita beer consumption has been flat over the past several years, wineries and liquor distillers have seen a significant uptick in their business. Many of the world's most popular brands fall under the Diageo umbrella, including: Crown Royal, Guinness Stout, Johnny Walker, Smirnoff, Captain Morgan, Jose Cuervo, and Tanqueray. And millions of consumers have been migrating to high-end premium brands, playing right into Diageo's strength. Thanks to several waves of global consolidation, the total number of alcohol distributors has declined sharply over the past couple decades, and Diageo is an imposing force in the industry. And with its size and scope, Diageo is able to leverage its success into new markets. For example, its international market segment (including Latin America, Africa, and the Middle East) is seeing double-digit sales growth -- allowing the company to continue growing despite already universal popularity in most developed markets. Along with a bright sales picture, Diageo also enjoys powerful economies of scale, intoxicating net profit margins of around 20%, and very low capital requirements. Last year, the company's capital expenditures ($549 million) only amounted to about 3.5% of total sales ($16 billion). As a result, DEO is able to generate barrels of annual free cash flow -- much of which it uses to fund a healthy annual dividend payment. In all, Diageo is a classic wide-moat firm whose products are largely insulated from cyclical slowdowns or economic turbulence -- and is still within reach of value investors.
NYSE Euronext (NYSE: NYX)
The New York Stock Exchange is the world's largest and most liquid stock exchange, with approximately 3,300 listed companies valued at more than $25 trillion. In exchange for "superior services and outstanding market quality and visibility," annual listing fees on the "Big Board" can reach as much as $500,000. Most of the nation's older blue-chip companies (and a number of foreign standouts) trade on the venerable NYSE floor, while flashier high-tech firms typically take up residence in the Nasdaq. Over the past 15 years, global trading volume has been growing at a healthy +25% annual clip, and that trend should remain in place for years to come. Growing populations, reduced trading costs, and technological innovations (like online financial information and research) have all helped bring stock ownership to the masses. In 1983, just one-fifth of all U.S. households owned stocks. Today, that percentage has grown to one-half, and tens of thousands of people join the ranks of new investors every year. Better still, regardless of whether investors' picks make or lose money, the NYSE receives a small cut from every transaction. Like many of its rivals, the NYSE has looked to secure a major acquisition, and the company found its prize with Euronext (the union of exchanges in Paris, Brussels and Amsterdam) -- the second largest stock/futures exchange in all of Europe. The move will benefit shareholders for a number of reasons. Cost savings from the transatlantic merger are expected to reach $275 million per year, which could pave the way for the firm's already lofty operating margins to expand well beyond the 50% mark. Second, the acquisition will dramatically boost transaction volume and allow the company to capitalize on its scaleable business model. Finally, Euronext will spice up the NYSE's product offerings by adding futures contracts to the mix. Futures volume is not only growing rapidly, but it also tends to be far less commodity-like than equity trading -- offering greater pricing power. This is a business where size matters, not only in terms of liquidity (investors are drawn to liquid exchanges where prices are efficient and instantly adjust to changes in supply and demand), but also because of economies of scale. As the largest and most liquid exchange in the world, the New York Stock Exchange benefits from a strong "network effect." At the same time, companies want to list on an exchange where they have the highest visibility, which gives the NYSE's listing business a wide economic moat. NYSE has many of the hallmarks that Buffett looks for: scalability, hefty operating margins, significant barriers to entry, and (unless people suddenly stop investing in stocks, options, and futures) robust demand and very little threat of obsolescence. With its infrastructure already in place, any incremental revenues should flow largely to the bottom line, pushing shares of this venerable firm forward in the years ahead.
(THIRD) What is Buffett Buying Right Now?
Over the past few decades, Buffett has amassed a fortune by investing in some of the world's greatest companies, including Coca-Cola and Procter & Gamble. But if you really want to profit form Buffett's investing genius, then might be interested in what he's buying RIGHT NOW. Here's a closer look at a few of Buffett's more recent purchases . . .
ConocoPhillips (NYSE: COP) -- Warren Buffett has been pilling up shares of this dividend-paying oil company. He recently bought $1.2 billion worth of the company's stock. This makes Berkshire Hathaway the largest holder of Conoco shares, with 5.6% of shares outstanding, a holding valued at around $4 billion.
CarMax (NYSE: KMX) -- Buffett recently invested $500 million into this promising retail stock, buying 21 million shares.
General Electric Co. (NYSE: GE) -- In an unexpected move, Buffett bought $3 billion worth of GE preferred shares. These shares will provide Buffett with an annual dividend yield of 10%. The legendary investor bought into this blue-chip company on very favorable terms in a deal The Wall Street Journal "vintage Buffett."
Goldman Sachs Group (NYSE: GS) -- Berkshire Hathaway just bought $5 billion in perpetual preferred shares of Goldman and received warrants to buy $5 billion more at $115 each any time during the next five years. (A warrant allows its holder the right to buy shares during a certain time for a set price.) Goldman has taken only $4.9 billion in subprime writedowns so far, a tiny fraction of the $29.1 billion recorded by Merrill Lynch (NYSE: MER) or the $37.7 billion incurred by UBS (NYSE: UBS). It also hasn't posted a quarterly loss since its IPO in 1999.
Sanofi-Aventis SA (NYSE: SNY) -- Buffett recently upped his stake by +8% in this French pharmaceutical company and currently holds a total of 3.9 million shares. Soon after Buffett reported his additional purchase, SNY announced it would be replace its CEO with experienced veteran Chris Viehbacher, executive director and president at GlaxoSmithKline (NYSE: GSK).
NRG Energy (NYSE: NRG) -- NRG is the newest addition to the Berkshire Hathaway portfolio. Buffett started by picking up a little more than 3.2 million shares of the wholesale power generation company, and has been adding shares to his holdings since then. At last count, Buffett's stake in NRG was up to 5 million shares. While NRG is the only utility in the portfolio, Berkshire itself became one of the largest utility companies in the U.S after it acquired MidAmerican Energy and PacifiCorp.
Burlington Northern Santa Fe (NYSE: BNI) -- Burlington Northern boasts monopoly control over some of the most valuable railroad lines in the U.S. Buffett has already invested over $5 billion in BNI, and he's buying even more shares, bringing his total stake in the company up to nearly 20%.
UnitedHealth (NYSE: UNH) -- UnitedHealth offers health insurance products as well as services related to employer-managed healthcare plans. Berkshire's stake in UnitedHealth is relatively small at less than 0.5% of the company's outstanding stock. But Berkshire has been buying UNH lately, recently adding 1.2 million shares to its portfolio.
POSCO (NYSE: PKX) -- It's also easy to see why Buffett might admire a company like POSCO, the world's third-largest steelmaker. This undervalued market leader has a dominant stranglehold on the South Korean steel market, and it's also fueling the economic boom in China. In mid-2007, we learned that Berkshire had shelled out $572 million to acquire a 4% stake in PKX.
US Bancorp (NYSE: USB) -- Berkshire Hathaway has increased its stake in this bank by 45.6 million shares since the end of 2006 - making it one of the biggest share position buildups Buffett has ever amassed. US Bancorp has everything Buffett loves, and it yields just over 5%.
Ingersoll-Rand (NYSE: IR) -- This is a classic Buffett value play: he has bought a business he would be thrilled to hold at a rock bottom price. This $12 billion maker of climate-control systems, industrial equipment and security technology is trading at just 3.4 times earnings. But with a backlog of orders worth a billion dollars its prospects look good.
(FOURTH) What is Buffett Selling?
Anheuser-Busch (NYSE: BUD) -- Buffett recently sold 20 million shares of the iconic brewer. He also helped arrange its sale to Belgium's InBev in a $52 billion deal