buffett investment methodology focus investing (1)

7/27/2019 Buffett Investment Methodology Focus Investing (1)

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BUFFETT INVESTMENT

METHODOLOGY

WBW: Chapters 1-3 and 10 and 12

WBP: Chapters 1-4

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Focus Investing

Modern Portfolio Theory (MPT) encouragesdiversification to reduce risk.

Buffett believes that the benefits ofdiversification are more than offset by theproblems associated with managing largenumbers of securities

Buffett prefers to make large bets on a smallnumber of companies in his circle of

competence Buffett has dubbed this approach Focus

Investing

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Wells Fargo 2007-2012

Finance.yahoo.com

WFC

Historical prices Monthly data

Jan 1, 2007 Dec 31, 2012

3

Also available on the Blackboard page


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Wells Fargo

4

1. Sort the data (oldest to newest, A to Z)2. Use the adjusted close column3. Make a chart of the adjusted close from Jan 2007 Feb 2009

i. Add the monthly volume to this graphii. Add a secondary axis

4. Calculate the monthly % return for each month 2007-2012

5. Calculate the value of $100,000 invested at the end of January 2009each month to December 2012

6. Make a chart of your values in part (5)7. Calculate your compound monthly return and annualize this number

=

1

= 1 +

= 1 + 2

1 =

1

Use the COUNT function


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Charlie Munger

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Charlie Munger: Lessons From an Investing Giant

August 30, 2013, page B1

Summary: In the first quarter of 2009, Charlie Munger invested 71%of the cash of a small publishing unit he chairs in bank stocks.Sources say the largest positions were in Wells Fargo and USBancorp.

StockAverage annual Return

1Q2009 end 2012

Wells Fargo 18.57%

US Bancorp ?

Homework: Repeat the WFC example with US Bancorp (USB) data from Jan 2007-Dec

2012. Find the average monthly return and annualize the return. YOU MUST USE THE

COUNT function!!!! Do this in groups of 2 or 3.


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Lessons

What you can learn from Charlie:

Individual investors can be patient

You can sit on cash, professional money managers

cannot

You can be brave and make bold moves

Especially if you are young

How old is Charlie?

6

Charlies advice: Sit on your ass regardless of what the investment crowd is

doing until a good investment finally materializes.


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Lessons

How do you know when a good investment is

available?

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Most money managers spend their days in meetings, riffling through emails,

staring at stock-quote machines with financial television flickering in the

background, while they obsess about beating the market.

Mr. Munger and Mr. Buffett, on the other hand, sit in a quiet room and read

and think and talk to people on the phone.

By organizing their lives to tune out distractions and make fewer

decisionsMr. Munger and Mr. Buffett have tilted their odds toward making

better decisions.

From the WSJ article:


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Educational Influences on Buffett

Benjamin Graham Partner in brokerage firmof Newburger, Henderson & Loeb by thetime he was 25 he was making an annual

salary of $600,000 (in 1919). Ruined in the 1929 crash taught night

classes in finance at Columbia and (with DavidDodd, a finance professor at Columbia), wroteSecurity Analysis (1934) and The IntelligentInvestor(1949)

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Benjamin Graham

Introduced Buffett to the concept of Margin ofsafety

Margin of safety is the difference between the

intrinsic value of a company and the companysprice.

Suggested buying stocks selling for less than 2/3of net asset value. (p. 15 WBW)

Stock price should be less than net current assets

Focus on low-P/E stocks

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Benjamin Graham

Approach focused on stocks deeply out-of-

favor with the market.

Graham felt that market frequently mispriced

stocks by overreacting to bad news.

Early use of the concept of reversion to the

mean

Focused on statistics and bargain stocks little

interest in management.

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Benjamin Grahams Stock Selection

Rules for Defensive Investors

Adequate size not less than $100 million of annual sales for

industrial companies and $50 million of assets for public utilities

(1970)

Strong Financial Condition 2:1 current ratio and long term debt

< working capital Positive earnings for the common stock in each of the past ten

years.

Dividend payments in each of last 20 years.

Minimum increase of at least 1/3 in per-share earnings in the past10 years, using 3 year averages at the beginning and the end.

Price


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Excel Exercise

12

BEN GRAHAM DEFINSIVE INVESTING WORKSHEET


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Philip Fisher

Started Fisher & Company in 1931 after graduating from

Stanfords Graduate School of Business Administration.

Suggested investing in firms with above-average potential

and highly capable management.

Looked at profit margins and ability to grow without

external financing (as external financing would dilute

existing stockholders ownership).

Focus on integrity of management, depth of managementand relationship between management and employees.

Portfolios included fewer than 10 companies

Extensive interviews with companies and competitors.

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John Burr Williams

PhD Dissertation at Harvard was The Theory

of Investment Value introduced the concept

of the dividend discount model.

Buffett discounts owners earnings instead of

dividends, and uses the 10-year government

bond rate as the interest rate (or if interest

rates are very low, the average cumulativereturn of the overall stock market).

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Charlie Munger

Grew up in Omaha

Had a successful law practice in Southern Californiaand also ran an investment partnership.

Bought shares of Blue Chip Stamps and eventuallybecame chairman of its board. Berkshire and Blue ChipStamps merged in 1978 and he became Berkshires vicechairman. Now also chairman of Wesco Financial (80%owned by Berkshire).

Believes in paying a fair price for quality companies. Itis far better to buy a wonderful company at a fair pricethan a fair company at a wonderful price.

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Berkshire as an Insurance Company

Read Chapter 3 on your own it discusses

how Berkshires insurance business provides

that cash that funds Berkshires investments.

($44.2 billion in 2003).

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Focus Investing (Cont.)

Modern Portfolio Theory (MPT) stressesdiversification. Harry Markowitz (1952) efficient frontier and risk-

return tradeoff and concept of covariance.

Bill Sharpe (1963) concept of market risk (beta) Fama (1963) concept of efficient market

Buffett does not believe that investors always

behave rationally (an assumption of MPT), andthus doesnt believe that the market is alwaysefficient.

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Buffett on MPT

If prices are not always rational, measuring risk relative to themarket may not be meaningful.

Diversification reduces bad outcomes, but also reduces the chanceof good outcomes thus insuring that you will get averageoutcomes with less variability.

To beat the market, you need to be willing to accept morevolatility.

To achieve the maximum benefits from diversification, you mustinvest in lots of companies. It is likely that you will have to investoutside of your circle of competence and that you will not be ableto fully understand and analyze each investment.

Uses margin of safety concept to reduce risk, not calculations ofbeta and standard deviation.

Makes big bets on high probability events instead of pursuingdiversification.

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Buffett on MPT

Read the first part of Chapter 3 (WBP) on your

own.

Discusses results of successful focus investors

Bill Ruane (Sequoia Fund), John Maynard

Keynes, Charlie Munger and Lou Simpson

(GEICO).

Summarizes Buffett speech on efficient

markets in 1984 at Columbia University.

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Focus Investing Statistics

Look at WBP p. 54-62

Randomly constructed portfolios of different

sizes.

Focus portfolios beat the market but had

much higher volatility.

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buffett investment methodology focus investing (1)

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