Fin 4201/8001Topic 2: The Three Wise Men

WB – PhilosophyWB – Philosophy

Investment selectionInvestment selection ““The best way to hit a home run: Don’t The best way to hit a home run: Don’t

swing at everything; wait for a fat pitch.” swing at everything; wait for a fat pitch.” ““You find these well-smoked, down-to-You find these well-smoked, down-to-

the-nub cigars, but they’re free. You the-nub cigars, but they’re free. You pick them up and get one free puff out pick them up and get one free puff out of them. Anything is a buy at a price.”of them. Anything is a buy at a price.”

Portfolio managementPortfolio management ““The best way to outperform the market: The best way to outperform the market:

Don’t load up on hundreds of stocks; Don’t load up on hundreds of stocks;

WB – PhilosophyWB – Philosophy

On Ben GrahamOn Ben Graham ““(Graham) wasn’t about brilliant investments (Graham) wasn’t about brilliant investments

and he wasn’t about fads or fashion. He was and he wasn’t about fads or fashion. He was about sound investing, and I think sound about sound investing, and I think sound investing can make you very wealthy if you’re investing can make you very wealthy if you’re not in too big of a hurry. And it never makes not in too big of a hurry. And it never makes you poor, which is better.” you poor, which is better.”

““Next to my dad, Ben Graham had more Next to my dad, Ben Graham had more impact certainly on my business life than any impact certainly on my business life than any other individual.”other individual.”

Portfolio managementPortfolio management ““The best way to outperform the market: The best way to outperform the market:

Don’t load up on hundreds of stocks;Don’t load up on hundreds of stocks;

The Three Wise MenThe Three Wise Men

““I’m 15% Philip Fisher and 85% I’m 15% Philip Fisher and 85% Benjamin Graham”Benjamin Graham” Benjamin GrahamBenjamin Graham Philip FisherPhilip Fisher Charles MungerCharles Munger

Ben Graham (1894 – 1976)Ben Graham (1894 – 1976)

Dean of financial analysis.Dean of financial analysis. ““before him there was no (financial before him there was no (financial

analysis) profession and after him they analysis) profession and after him they began to call it that.” --Adam Smith began to call it that.” --Adam Smith (1972)(1972)

Most famous for:Most famous for: Security AnalysisSecurity Analysis, coauthored with David , coauthored with David

Dodd and published in 1934Dodd and published in 1934 The Intelligent InvestorThe Intelligent Investor, published in 1949, published in 1949

Ben Graham (1894 – 1976)Ben Graham (1894 – 1976)

Columbia University Bachelor of ScienceColumbia University Bachelor of Science Messenger in Wall Street brokerage firmMessenger in Wall Street brokerage firm By 1919 (age of 25) was a partner and By 1919 (age of 25) was a partner and

earning $600,000/yearearning $600,000/year In 1926, formed own partnership – In 1926, formed own partnership –

Graham NewmanGraham Newman Dissolved the partnership and retired in Dissolved the partnership and retired in

19561956

Ben Graham (1894 – 1976)Ben Graham (1894 – 1976)

While at Graham-Newman taught night While at Graham-Newman taught night courses in finance at Columbia courses in finance at Columbia UniversityUniversity

Two most important contributions to Two most important contributions to BuffettolobyBuffettoloby Investment vs. SpeculationInvestment vs. Speculation A systematic (Quantitative) approach to A systematic (Quantitative) approach to

investment with the concept of investment with the concept of Margin of Margin of SafetySafety..

Investment vs. SpeculationInvestment vs. Speculation ““An investment operation is one An investment operation is one

which, upon which, upon thorough analysisthorough analysis, , promises promises safety of principalsafety of principal and and satisfactory returnsatisfactory return. Operations not . Operations not meeting these requirements are meeting these requirements are speculative.” speculative.”

Investment in bonds can also be Investment in bonds can also be speculative. What is important is a speculative. What is important is a quantitative approach to investmentquantitative approach to investment

Three reasons for the Crash Three reasons for the Crash of 1929of 1929

Manipulation of stocks by the Manipulation of stocks by the exchanges and investment firmsexchanges and investment firms

Practice by banks of lending money Practice by banks of lending money for the purpose for buying stocksfor the purpose for buying stocks

Uncontrolled optimism that was Uncontrolled optimism that was driving it alldriving it all

The first two have been solved to a The first two have been solved to a large extentlarge extent

Three approaches to Three approaches to investmentinvestment

Cross-section approachCross-section approach Equivalent to today’s indexing or Equivalent to today’s indexing or

passive investingpassive investing Anticipation approachAnticipation approach

Short-term selectivity – Invest in near Short-term selectivity – Invest in near term favorableterm favorable

Growth stock – Invest in companies with Growth stock – Invest in companies with earnings growth > averageearnings growth > average

Margin of Safety approachMargin of Safety approach

Margin of Safety ApproachMargin of Safety Approach

After deciding what to buy (later), After deciding what to buy (later), investor has to decide when to buyinvestor has to decide when to buy Buy when everything is selling cheap Buy when everything is selling cheap

(bear)(bear) Buy when the particular stock is trading Buy when the particular stock is trading

below its intrinsic value, irrespective of the below its intrinsic value, irrespective of the market conditionmarket condition

Graham believed the first approach is Graham believed the first approach is futile.futile.

Margin of Safety ApproachMargin of Safety Approach

For bonds, margin = Earnings – fixed For bonds, margin = Earnings – fixed chargescharges

Stocks, “When a stock is priced well Stocks, “When a stock is priced well below its intrinsic value, a margin of below its intrinsic value, a margin of safety automatically exists.” safety automatically exists.”

Intrinsic value?Intrinsic value? ““that value which is determined by facts”that value which is determined by facts” Earning potentialEarning potential Qualitative factorsQualitative factors

Art and science of financial Art and science of financial analysisanalysis

Quant = Balance sheet, Income Quant = Balance sheet, Income Statement, Cash flows,…Statement, Cash flows,… Company assets, earnings and Company assets, earnings and

dividends, and any future DEFINITE dividends, and any future DEFINITE prospectsprospects

Qualitative – not easy, but essential Qualitative – not easy, but essential to intrinsic value to intrinsic value Management capabilityManagement capability Nature of businessNature of business

Margin of SafetyMargin of Safety Graham believed that there is little Graham believed that there is little

margin of safety if the qualitative margin of safety if the qualitative factors make a major part of the factors make a major part of the intrinsic value.intrinsic value.

Buy a company for less than two-Buy a company for less than two-thirds of its net asset value (NAV)thirds of its net asset value (NAV) No weight to PPENo weight to PPE Deduct all short/longterm liabilitiesDeduct all short/longterm liabilities

focus on stocks with low price-to-focus on stocks with low price-to-earnings (P/E) ratioearnings (P/E) ratio Wrong market price & mean reversionWrong market price & mean reversion

Philip FisherPhilip Fisher

Graduated from Standford’s Graduated from Standford’s Graduate School of BusinessGraduate School of Business

Analyst at Anglo-London-Paris Bank Analyst at Anglo-London-Paris Bank in San Franciscoin San Francisco

After two years head of Bank’s After two years head of Bank’s Statistical DepartmentStatistical Department

Started advisory firm, Fisher & Started advisory firm, Fisher & Company in 1931Company in 1931

Philip FisherPhilip Fisher

Superior profit in firms with Superior profit in firms with above average above average potentialpotential with the most with the most capable capable managementmanagement..

Point system to identify good companies Point system to identify good companies ““Investment success depends on finding Investment success depends on finding

companies that can sustain above-average companies that can sustain above-average growth, in both sales and profits, over a growth, in both sales and profits, over a period of several years. Short-term results period of several years. Short-term results are deceptive.”are deceptive.”

Philip FisherPhilip Fisher

Fortunate and ableFortunate and able Aluminum Company of AmericaAluminum Company of America

Fortunate because ableFortunate because able DupontDupont

““Investment success depends on finding Investment success depends on finding companies that can sustain above-average companies that can sustain above-average growth, in both sales and profits, over a growth, in both sales and profits, over a period of several years. Short-term results period of several years. Short-term results are deceptive.”are deceptive.”

Essential QualitiesEssential Qualities

1)1) R&D expenseR&D expense

2)2) Strong MarketingStrong Marketing

3)3) Low break even; lowest-cost Low break even; lowest-cost producersproducers

4)4) Ability to grow without new equityAbility to grow without new equity

5)5) Superior managementSuperior management

““Superior management is the key Superior management is the key to superior market performance.”to superior market performance.”

1)1) Long term target of consistent Long term target of consistent performance?performance?

2)2) Management of unquestionable Management of unquestionable integrity and honesty?integrity and honesty?

3)3) Do managers communicate with Do managers communicate with shareholders?shareholders?

4)4) Relationship between management Relationship between management and employees?and employees?

5)5) Management characteristics vs. Management characteristics vs. peerspeers

Scuttlebutt approachScuttlebutt approach

Find out what kind of reputation the firm Find out what kind of reputation the firm hashas Cross-sectional view of the firmCross-sectional view of the firm Customers, vendors, former employees, Customers, vendors, former employees,

competitors, trade associations…competitors, trade associations… Since time consuming, Fisher’s portfolio Since time consuming, Fisher’s portfolio

was focused on a few stocks. was focused on a few stocks. ≈ ≈ Buffett’s “Circle of Competence”Buffett’s “Circle of Competence”

Charles MungerCharles Munger

““Charlie-and-I”Charlie-and-I” Functionally investment co-managerFunctionally investment co-manager Son of lawyer and grandson of Federal judgeSon of lawyer and grandson of Federal judge Harvard Law School - Practiced law in LA; Joined Harvard Law School - Practiced law in LA; Joined

BRK in 1978BRK in 1978 ““Look for companies that generate high cash Look for companies that generate high cash

earnings and require low capital expenditure.”earnings and require low capital expenditure.” ““It is far better to pay a fair price for a great It is far better to pay a fair price for a great

company than a great price for a fair company.”company than a great price for a fair company.”

See’s Candy 1972See’s Candy 1972

Turning point in the investment Turning point in the investment philosophy of Berkshire Hathawayphilosophy of Berkshire Hathaway

Charlie convinced Warren See’s was a Charlie convinced Warren See’s was a good buy at three times the book value.good buy at three times the book value.

Not picking up as many cigar butts!Not picking up as many cigar butts!

Put it all together…Put it all together…it spells successit spells success

Graham = buy cheap, margin of safety, Graham = buy cheap, margin of safety, ignore management and sector (Quant)ignore management and sector (Quant) Some of WB’s investments were cheap for a Some of WB’s investments were cheap for a

reason (original Berkshire Hathaway)reason (original Berkshire Hathaway) View stocks as investments = long-termView stocks as investments = long-term

Fisher = more business and Fisher = more business and management focused (Qual)management focused (Qual)

Charlie = move WB from 85-15 to 50-50Charlie = move WB from 85-15 to 50-50