We Study Billionaires - The Investor’s Podcast Network - TIP487: Warren Buffett’s 12 Investment Principles (with a Case Study)

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to The Investors Podcast. I'm your host, Clay Fink, and on today's episode, I'm going to be sharing Warren Buffett's 12 investment principles, as well as looking into a case study of Coca-Cola on how Buffett applied these principles in practice. Buffett and Berkshire Hathaway first invested $1 billion in Coca-Cola in 1988, and it has been one of his big winners over his investment career. I've recently read Robert Haxstrom's book, The One,

Starting point is 00:00:30 Warren Buffett way, and I really have to give all credit to him for today's episode as he outlined these principles and a number of case studies in his book, which I thoroughly enjoyed reading and recommend you check out if you'd like to learn more about Buffett's investing strategy. In case you missed it, my previous two episodes discussed Warren Buffett's journey as an investor and how his process changed and evolved over time. Those are episodes TIP 482 and TIP 484 if you'd like to check those out. And I'll be sure to link those in these show notes as well so you can easily find them. Before we dive into the episode, I'm really excited to share an upcoming event hosted by The Investors Podcast Network. Beginning on Monday, October 17th, we are launching a stock pitch

Starting point is 00:01:14 competition for you all to compete in. And the first place winner will receive $1,000 plus a year-long subscription to our TIP finance tool and more. You won't want to miss out on your chance to win $1,000. If you are interested in participating, please visit TheInvesterspodcast.com slash stock dash competition. The last date to submit your stock analysis will be on Sunday, November 27th. Additionally, you will need to be signed up for our daily newsletter, we study markets, where we will announce the winners. All entries can be submitted to the email newsletters at theinvestorspodcast.com.

Starting point is 00:01:52 Again, to get more info, please go to theinvestorspodcast.com slash stock. dash competition. Best of luck to those participating. With that, let's dive right into today's episode covering Warren Buffett's 12 investment principles. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, in chapter three of Hachstrom's book, he has the chapter titled, Buying a Business, the 12 immutable tenants. Buffett is someone who believes that the best way to build wealth is to own very good businesses over long periods of time. And there are two ways he can go about

Starting point is 00:02:45 that, which very much includes a similar process, and that's buying the whole business outright and buying stock in the publicly traded company. Buffett prefers buying the business outright because it allows him to influence the company's capital allocation decisions, but Buffett, of course, doesn't limit his purchases to just wholly own businesses. The benefits for him, of investing in the stock market is that, one, he has thousands of companies to choose from, giving him a lot of choices to potentially invest in. And two, with changes in Mr. Markets' mood swings, the stock market gives him opportunities to find bargains or stocks trading at great prices to start buying shares in the company. So from this perspective, Buffett states that,

Starting point is 00:03:26 quote, when investing, we view ourselves as a business analyst and not a market analyst, not as macro analysts and not even as security analysts, end quote. This means that Buffett first and foremost thinks from the perspective of a business person. So he's looking at how the business model operates, how profitable it is, what the company's financial position looks like, how competent the management team, as well as the company's purchase price. Hagstrom studied how Buffett invested and simplified his process down to what he calls 12 Tenets or Principles. Within that, the 12 principles fall into four categories. One, business tenants,

Starting point is 00:04:06 which are the three basic characteristics of the business. Two, management tenants, which are three important qualities that senior managers must display. Three, financial tenants, which are the four critical decisions that the company must maintain. And four, market tenants, which relate to two tenants around the company's price. Before we dive in, Hagerstrom does point out that not all of Buffett's purchases fit perfectly into these 12 tenants. But for the most part, these tenants or principles are the core of how he invests. So let's start with the business tenants. It's important to remember that when you're buying stocks, you're buying pieces of an actual business. So many people go out and buy a stock, then when they see their stock price go down,

Starting point is 00:04:48 they sell hoping that they are avoiding even bigger losses. So it's important to have that mindset of recognizing that stocks are real businesses providing real product. and real services to real people. The first business tenant, Haxstrom, lays out in his book, is for the business to be simple and understandable. This principle is so basic yet, I think it can be so overlooked by people. Oftentimes people will ask me about a particular stock and I'm just like, I don't really have an opinion on that company because I can't really say I understand the business fully. Just throwing two examples out there. Invidia and Roku are examples of stocks that look to be good companies. They're growing really fast and they look to potentially be really

Starting point is 00:05:33 successful businesses. But I honestly can't say I fully understand their competitive position. Therefore, I just completely avoid companies like those. Every single business that Warren has invested in, he has a pretty good understanding of how all of the businesses operate. When he has a great understanding of the business, he is ensuring that he is playing a game in which he is capable of winning. If he were to invest in some sort of obscure tech company, He honestly isn't equipped to win that game, so why even attempt to play that type of game? As Haxstrom put it in his book, quote, Buffett also tends to avoid businesses that are solving difficult problems. Experience has taught him that turn-around's seldom turn. It can be more

Starting point is 00:06:14 profitable to look for good businesses at reasonable prices than difficult businesses at cheaper prices. Buffett admits Charlie and I have not learned how to solve difficult business problems, but what we have learned to do is avoid them to the extent we have been successful. It is because we have concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. A helpful way for me to wrap my head around a business is to actually interact with it in my real daily life. With a company like Costco, for example, I can understand the appeal of being a member

Starting point is 00:06:51 and why it might be difficult for competitors to disrupt them. If I were just reading about Costco as an outsider that has never visited a store, then it might be difficult to fully understand the competitive moat they've built over the years. It also reminds me of Peter Lynch's investment philosophy of looking at a business that is in your day-to-day life. A company like Starbucks is a prime example of this as my local Starbucks practically has cars lined outside of the parking lot to buy Starbucks coffee in the drive-thru every single day. This also ties into. to Buffett's idea of investing within your circle of competence. It's important to define what you know.

Starting point is 00:07:31 It's also important to define what you don't know well because that's where you can really get into trouble. So again, business principle number one is for the business to be simple and understandable. Business principle number two. The business must have a consistent operating history. So when Buffett invest, he isn't looking for a new innovative product that's going to completely change the world, or looking at a company that is in an industry that is constantly changing. This alone eliminates a large number of stocks that just simply aren't investable for him. He wants a business that has been producing a similar product or service for many years because if the business has had sustainable and consistent growth and profits over the years,

Starting point is 00:08:14 then he's able to have confidence in assessing whether that will continue into the future or not. Buffett has been quoting us saying that severe change in exceptional returns usually do not mix. For example, Buffett has invested in many industries which are considered staples of the economy, such as railroads, energy, and insurance. These industries are going to continue to be staples and key parts of our economy in some form or fashion in the future. So Buffett likes how stable and reliable these industries truly are. And this is a big reason why Buffett has often avoided tech companies. Over his life, he has seen so many tech companies come and go that he just simply believes that he's better off investing in a company that is very likely to

Starting point is 00:08:58 continue to grow consistently for the years to come. The future is definitely difficult to predict, but assuming that a stable industry will continue to produce profits for a very long time for the very best companies is still a reasonable assumption to make. So business principle number 2, the business must have a consistent operating history. Business principle number three, the company must have favorable long-term prospects. When Buffett is narrowing down the type of businesses he views as great businesses, he oftentimes wants three things. He wants to ensure that the company provides a product or service that, one, is needed or desired by society, two, it has no close substitute, and three, it is not regulated. Having these three attributes allows a company to have

Starting point is 00:09:44 pricing power and earn above average returns on capital over time. Buffett says he likes stocks with high returns on invested capital that is likely to persist as well as a company with a long-term competitive advantage. This is drilling down to the term Buffett uses often, which is a moat. A moat is what gives a great company a clear advantage over its competitors and protects the business from invasion by competition wanting to tap into their share of profits. So a clear competitive advantage is crucial as well as for that competitive advantage or moat to be durable and is able to stick around for a really long time. Buffett says that a great company is one that will be great for 25 to 30 plus years. Conversely, a bad business offers a product that is virtually undistinguishable

Starting point is 00:10:31 from the products of its competitors, which is a commodity. Years ago, basic commodities included oil, gas, chemicals, copper, lumber, wheat, and so on. Today, products like computers, automobiles, airline services, and banking have become commodity-like products. So that wraps up Buffett's three business tenants, which include the company must be simple and understandable, it must have a consistent operating history, and it must have favorable long-term prospects. Next, Haxstrom lays out Buffett's three management tenets. Buffett pays very close attention to the quality of the management. He tells us that the companies or stocks, Berkshire purchases must be operated by honest and competent managers whom he can admire and trust. Even if they're

Starting point is 00:11:17 managing a very high-quality business, he will never make an investment in a team he does not admire in trust, as he says, no matter how attractive the prospects of their business, We've never succeeded in making good deals with the bad person. The first management principle that Haxstrom lays out in his book is that the management must act rationally. He states that, quote, the most important management act is the allocation of the company's capital. It is the most important because allocation of capital over time determines shareholder value,

Starting point is 00:11:49 end quote. Management needs to figure out how to best allocate capital in a way that maximizes shareholder value. This might mean taking the earnings. in paying out a dividend, or potentially taking those earnings and expanding their business in the U.S. or internationally, or even buying back shares in the company. Once a company has mature to some degree and is to the point where they're producing free cash flows, management is going to need to determine what to do with those cash flows.

Starting point is 00:12:16 If the money could be reinvested back into the business at a rate of return that is higher than their cost of capital, then it is logical to do so. Retaining earnings and reinvesting at a rate of return that is lower than the cost of capital is irrational, and it's actually quite common on Wall Street. This is why Buffett wants to see high return on invested capital in a business. It shows that the company is able to produce a lot of cash relative to the cash that is put into the business. Munger is also known for saying the following, quote, over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years, and you can you, you

Starting point is 00:12:55 you hold the stock for 40 years, you're not going to make much different than a 6% return, even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with a fine result, end quote. Costco is a great example of this. They had return on invested capital just over 10% in the 2000s, and ever since 2010, the ROIC has steadily risen to be in the high teens. Meanwhile, Costco's stock has risen on average by 13.6% per year, excluding dividends since 1998.

Starting point is 00:13:33 Of course, Costco's earnings multiple has risen substantially over the years as well, so return on invested capital is not the sole driver in its long-term performance. And as many of you in the audience know, Munger has been a huge fan of Costco over the years. So if a company is not able to reinvest back into the business at high rates of return, Buffett liked to see the business either returning that capital back to shareholders through a dividend or through share buybacks. Each method has its own pros and cons. Returning the capital through a dividend allows the shareholders to have the cash in their own hands. However, dividends are less tax efficient than share buybacks, as dividends are oftentimes taxed in the U.S. to some degree

Starting point is 00:14:14 for most investors. Buffett, who's clearly a spectacular capital allocator, prefers to perform share buybacks rather than issuing a dividend. Berkshire Hathaway has never paid a dividend, but he has repurchased shares in the past. The benefit of doing so is twofold. First, management can opportunistically time when they perform share buybacks, and it's oftentimes wise to repurchase shares when the stock is trading below its intrinsic value. Second, when management repurchases shares, it shows they are having the shareholders' best interest at heart, as for each share they repurchase, they are increasing the current stockholder's overall ownership in the business. For example, if Buffett were to purchase 1% of shares outstanding in a company, and that company in turn repurchased 5% of shares outstanding

Starting point is 00:15:00 year after year, after 14 years, he would then own 2% of shares outstanding as the share repurchases would have effectively doubled his stake in the company. Apple is one example of a company Buffett owns that ruthlessly buys back shares. In 2021, Apple repurchased 85.5,000, Apple repurchased 85.5, billion dollars of their own shares. This is around 3.4% of total shares when looking at the shares outstanding at the beginning in the end of the year. So management principle number one, management must act rationally and act in shareholders' best interest. The second management principle outlined in the book is that management must act candid with shareholders. What this principle is really getting at is that Buffett wants to see that management is truthful, transparent,

Starting point is 00:15:47 and they aren't trying to hide anything from the shareholders. Buffett argues that through the mandatory reporting disclosures, management must present data that helps the financially literate readers answer three key questions. One, approximately how much is the company worth? Two, what is the likelihood that it can meet its future obligations? And three, how good a job are its managers doing given the hand that they've been dealt? Buffett frankly points out that most annual reports are

Starting point is 00:16:17 sham. I think a big reason that Buffett might be seeing this in annual reports is that because a lot of executives and CEOs are incentivized to increase their stock price as much as possible. So if they point out and talk about how they didn't execute effectively or the business has performed poorly historically, then that might lead to shareholders selling and further decreasing the stock price. Buffett is in a position where he isn't going to get fired and he openly talks about all of the many mistakes he has made over the years. The reality is that it's very hard to find management that talk as openly as Buffett about his mistakes. So I would just encourage the audience to not settle on a management team if you

Starting point is 00:16:58 aren't really sure they are honest and trustworthy people. Related to this idea is the third and final management principle, which is to resist the institutional imperative. The institutional imperative is the tendency of corporate managers to imitate the behavior of other no matter how silly or irrational that behavior might be. He wants managers who are critical thinkers and have the ability to think for themselves. He doesn't want somebody to make a decision just because all of their competitors are doing the same thing. This could be related to changing the status quo in the industry, making acquisitions,

Starting point is 00:17:35 selling executive compensation, etc. It kind of reminds me of the overall investment management industry. You might find one fund manager who is invested in 100 stocks, primarily picking many of the big names that other funds are holding. There's that old saying that you won't get fired for buying a stock like IBM. Because 20 years ago, that was considered a safe pick that everyone was buying. If you're trying to keep your job, then buying IBM is probably a pretty good idea. If it does well, then the fund benefits from that performance. If it does poorly, then, well, all of the other funds owned IBM too, and you still get to keep your job for

Starting point is 00:18:12 not stepping outside of the lines and crossing any boundaries. Whereas if you took the risk on a new company in the technology field, you run the risk of being humiliated if it does poorly, and then you might lose your job. It's all human nature, and it's against human nature to stand out and potentially look bad when compared to your peers. Really, it just boils down to the fact that many managers of companies are short-term thinkers. Whereas Buffett is looking for the managers that can overcome these human tendencies and make unconventional long-term decisions to the benefit of the shareholders. Another reason that many managers aren't very good at their job is because they rose the ranks within the company and got promoted to be on the executive team. So their whole life, they were

Starting point is 00:18:56 really good at one particular skill set, let's say sales, for example. Well, then they are on the management team. Now they need to be great at managing and allocating capital and resources, even though they've only done sales their whole career. Then now, Naturally, they turn to others to form their own opinions and decisions, and the institutional imperative takes hold in their decision-making. Determining the quality of a management team is more difficult than measuring the financial performance of a company simply because you can't directly measure things like rationality, candor, and independent thinking.

Starting point is 00:19:30 Having a good understanding of these aspects of the management can allow you as an investor to catch the early warning signs to the eventual financial performance of the company. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is.

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Starting point is 00:23:53 of the management team. One, look back at the annual reports from a few years back and compare what they were saying about the future and how that compares to the business today and how the business has changed over that period. Two, read the company's annual reports and see how it differs from that of their peers. Three, don't solely rely on quality managers when making investments. Not even the best managers can turn around a bad business. That wraps up the management tenants outlined in Hagstrom's book, The Warren Buffett Way.

Starting point is 00:24:23 Next, let's turn to the four financial tenants. The first financial tenant is to have an adequate return on equity. Related to our point earlier about the institutional imperative, it seems like Wall Street also puts a big emphasis on earnings per share. But a method that Buffett actually cares more about is the return on equity more so than the earnings per share. So what is the return on equity? The return on equity is the ratio of the operating earnings to the shareholders' or the book value. So if a company has a net income or operating earnings of $10 per share, and the book value is $100 per share, then the return on equity is 10% for that year. When looking at a company's return on equity or return on invested capital over a period of

Starting point is 00:25:09 years, you typically want to see these measurements either steady or increasing over time. A company that has a return on invested capital of greater than 10% is great, and it shows that the company is efficient at reinvesting their earnings back into the business to produce even more earnings over time. This is important because most stocks retain their earnings within the equity of the business. If a company's return on equity or return on invested capital is low or it is declining, this should tell you that the company is not efficient at reinvesting the earnings back into the business. Simply put, great businesses have high return on equity and high return on invested capital, say greater than 10%. Buffett knows that sometimes

Starting point is 00:25:50 adjustments need to be made in these calculations. In Berkshire's case, their books might have a massive increase in their equity holding in one particular year. Well, this would lead to lower levels of return on equity. So that's something to keep in mind when analyzing this figure. Also, you'll want to keep in mind how much debt the company has on its books. If a company is increasing their return on equity while also increasing their debt-to-income ratio, you should be mindful of this as the company may be getting too levered up and taking on too much risk, and the debt could eventually become a drag on the company's financial results. When analyzing the return on equity, return on invested capital, or really any reported number by a company, you don't want to put

Starting point is 00:26:31 too much focus on one particular year because one year might turn out to be an anomaly. For example, if the return on equity for a company is 5% per year and all of a sudden it's 10% in the most recent year, then you might not want to put too much weight on that 10% until you've seen the company produce that level, at least for a period of a few years. Wrapping up this tenant, Buffett believes that a good business should be able to earn a good return on equity without the aid of leverage. You should be suspicious of any companies that rely on leverage to produce good return on equity. The second financial tenant in Hagstrom's book is to calculate owner's earnings to get a true reflection of value. Buffett says that not all

Starting point is 00:27:14 earnings are created equal. Two companies might have the same level of earnings, but one company might be asset heavy, while the other might be asset light. Inflation and the need to replace the assets in the asset heavy business make the earnings between the two companies not really comparable. Oftentimes investors use free cash flow in estimating the earnings that a company produces, free cash flow is calculated as net income after taxes plus depreciation, depletion, amortization, and other non-cash changes. Buffett says that the problem with this figure is that it excludes capital expenditures, which includes investments for new equipment, plant upgrades, and other improvements needed to maintain its economic position and unit volume. In calculating the

Starting point is 00:27:58 economic earnings, Buffett wants to take the cash flow and adjust it for the capital expenditures as well as the working capital that might be needed in the future. The issue with calculating owner's earnings is that it's really up to the investor to estimate what the capital expenditures might be for a given year. And it's not really a precise calculation. It's really an estimate to the discretion of the investor. Haxstrom quotes John Keynes in his book with regards to this. Quote, I would rather be vaguely right than precisely wrong, end quote.

Starting point is 00:28:30 The third financial tenant is to look for companies with how. high profit margins. High profit margins show that a particular company is able to control costs and continues to produce free cash flows into the future. In my mind, this tenant also ties into finding a quality management team because a quality management team is always looking for ways to cut unnecessary costs and increase their profit margins. And if you want to learn from someone who is good at cutting costs, Buffett is one of the best managers at doing this, as Berkshire has completely minimized their corporate expenses, at least relative to their peers in their industry. All right, the fourth and final financial principle or tenant is for every dollar that is retained

Starting point is 00:29:12 within the company. Make sure the company has created at least $1 of market value. This tenant, I found to be an interesting one that Haxstrom included in his book. From a high level, the stock market tells you what the market is valuing any particular public company. Buffett believes that if he has selected a company with favorable long-term economic prospects run by ABLE and shareholder-oriented managers, the proof will be reflected in the increased market value of the company. So if the company is not doing a good job at redeploying the retained earnings over extended period of time, then the share price will be punished. If the company has an above-average return on investic capital over an extended period of time, then this

Starting point is 00:29:55 share price will be rewarded, assuming that you paid a fair price for the business. So Buffett has what's called the $1 rule he applies in determining the economic attractiveness of a business and how well management has accomplished its goal of creating shareholder value. Haxham states, quote, the increase in value should at the very least match the amount of retained earnings dollar for dollar. If the value goes up more than the retained earnings, so much the better, end quote. So Buffett wants each. dollar of retained earnings to eventually be translated into at least a dollar of increased market value in the business. So that wraps up the financial tenants. To recap, number one, focus on

Starting point is 00:30:36 return on equity, not earnings per share. Two, calculate owners' earnings to get a true reflection of value. Three, look for companies with high profit margins. And four, for every dollar retained, make sure the company has created at least $1 of market value. So far, we've looked at the business tenants, the management tenants, and the financial tenants. All of these are looking at the actual business, the people managing that business, and then the financial results from the business. What we haven't analyzed yet is the intrinsic value in comparing that to the market value or market price of the company. The market determines the price for the company, but it is the investor's job to determine what the actual or true or intrinsic value of the company is.

Starting point is 00:31:22 And remember that price and value are not necessarily the same. Sometimes Mr. Market has these massive mood swings to the upside or to the downside, for example. In March 2020, when we had a massive sell-off after looking in hindsight, that was obviously an opportunity to purchase many companies that were down 20, 30, 40 percent in a matter of weeks. In 2021, we saw many gross stocks rise by multiples above what they were in 2020. And now in hindsight, we can likely say that those prices went far above their intrinsic values in many cases. If the prices offered by the market were always efficient, then Warren Buffett would not be who he is today. He's been able to identify great companies that are trading at prices well below their intrinsic value

Starting point is 00:32:09 and then taking advantage of these opportunities. So the market tenants. The first market tenant is to determine the value of the business. Warren Buffett tells us that the value of a business is determined by the net cash flow expected to occur over the life of the business discounted at an appropriate interest rate. And as TIP has talked about for many years, this is really how you can value any financial asset, whether it be a bond, real estate, or anything that produces cash flows. You project out what the asset is going to make each year and then discount that back to today at an appropriate interest rate.

Starting point is 00:32:46 Starting with the earnings or the company's cash flows, it's so much easier to determine the value of a business if the business has steady cash flows similar to a bond. I wanted to pull up two examples to talk a little bit about what I mean. If you take a company like Coca-Cola, which Buffett owns, I pulled up our TIP finance tool to take a look at the free cash flows shown on our website. In 2018, their free cash flows were $6.3 billion, 2019, 9.4.5.5.5.5. $204 billion, $209 billion, and in 2021, $11.3 billion. So an investor would be able to take some sort of average over the past five years

Starting point is 00:33:27 or come up with some sort of reasonable assumption for the earnings and project that forward with some degree of confidence. On the other hand, if you look at a growth stock like Tesla, their top line revenue growth has been over 100% just over the past two years. In 2018, their free cash flows were negative. In 2019, they were $970 million. In 2020, $2.7 billion and in 2021, $5 billion. Just a slight tweak in your assumptions for the free cash flow growth of Tesla can drastically change your output for the intrinsic value of the company.

Starting point is 00:34:02 Whereas with Coke, it'll be much easier to come up with some sort of conservative and reasonable intrinsic value because the cash flows are much more stable and you can be much more confident in what the, cash flows will be in the future. If Buffett can determine the free cash flows with a high degree of certainty, then he probably won't even go about valuing the company. Over the years, Buffett has used the long-term U.S. government treasury rate as his discount rate. But now that interest rates are so low today, it's likely that he is using something higher for the discount rate to reflect a more normalized interest rate environment. Now, when it comes to valuation,

Starting point is 00:34:40 many people like to categorize companies into two camps, value investors versus growth investors. The value investing camp is people who want to invest a little bit more conservatively, and oftentimes they're purchasing companies with low price to earnings ratios and high dividend yields. These types of companies have been back tested to perform well, so that is the method of investing that many people will go with. As for growth investors, they're looking for companies that are growing revenue in earnings at an above-average clip, but that growth does not come without a price. So that's why these types of companies tend to have a higher PE and little to no dividends paid. Many people think that they have to pick one strategy or the other,

Starting point is 00:35:22 but Buffett says that the debate between the two schools of thought is nonsense and that growth and value investing are joined at the hip. Growth is actually a component of value and it is actually accounted for in Buffett's calculation of intrinsic value. So it's not necessarily true that just because a company has a low PE means that Buffett will like it, and just because the company has a high PE means that Buffett won't like it. All it really comes down to is whether the intrinsic value is trading well below the market price for him to consider buying it or not. This will bring us to our second market tenant, which is to buy at attractive prices. Buying a great business with capable management that is simple to understand and has an attractive business economics

Starting point is 00:36:05 simply isn't enough. The final piece of the puzzle is to ensure that you are purchasing the company at a sensible price. If you listen to my previous two episodes which discussed Buffett's investment journey, you know that Buffett took to heart Benjamin Graham's idea of ensuring an adequate margin of safety when making a purchase. A margin of safety allows for some room for error in his assessment of the business and how they end up performing in the future. A margin of safety will give Buffett some downside protection as well. For example, Apple today is trading at around $150 or $160 a share. If Buffett thinks the intrinsic value of Apple is $200 and he is incorrect in his assessment of the intrinsic value and it's actually lower than 200, well, then he isn't going to lose money

Starting point is 00:36:51 unless he is drastically off in his assessment of what the true value is. So there is some protection from the downside risk because he is ensuring that he is investing with a margin of safety. The other reason he wants to buy with the margin of safety is because this will help lead to above average returns. If he is buying something that is worth $200 for $160, then if he is right in his assessment of the intrinsic value, he will not only earn a return on how the business performs, but he will eventually realize the return of the stock price eventually reaching the intrinsic value of the company. So if a company earns 15% on its assets over the long run, the value of the stock will continue to trend upwards in that manner. On top of the market,

Starting point is 00:37:37 potentially recognizing that the company was trading below its intrinsic value. So the margin of safety is like the icing on the cake, as the stock may continue to trade well below its intrinsic value for some time, but it should continue to march upwards if it's a company with above average economic returns. So that wraps up Warren Buffett's 12 investment principles that are laid out in Haxstrom's book. Again, those principles are grouped into business tenants, management tenants, financial tenants, and market tenants. Next, I wanted to walk through some of the ideas around portfolio management, as well as the psychology aspect of investing.

Starting point is 00:38:16 Haxstrom outlined how Buffett considers himself a focus investor. This means that he focuses on just a few outstanding companies and typically holds these companies for many years. A lot of the work is done up front and, finding the right companies, and this greatly simplifies the task of portfolio management for him as an investor. Most of you are probably aware that anyone can invest passively in index funds, such as the S&P 500, and Buffett recognizes that anyone who invests in this manner will outperform most investment professionals. However, since Buffett has read practically every

Starting point is 00:38:54 investment book ever written, he knows that he has research and investing enough to really know what the heck he's doing and what he's talking about and how he can potentially outperform the market and achieve exceptional returns, even better than the indexes. He believes that focused investing significantly increases the odds of beating the index. This approach includes choosing a few stocks that are likely to produce above average returns over the long haul, concentrating the bulk of your investments in these stocks, and having the fortitude to hold steady during any short-term market fluctuations. Following the 12 tenants laid out previously, inevitably leads to great companies with a long history of superior performance and stable management. And that stability leads to

Starting point is 00:39:39 companies that are likely to provide solid returns in the longer term future as they have in the past. The heart of this approach is concentrating into companies with the highest probability of above average performance. Too often, investors are chasing the long-shot picks that have a potentially incredible payout, but most likely won't end up doing very well for investors. You want to invest in a way that stacks the odds in your favor and has a high probability of succeeding for patient investors. Haxstrom states that although focus investing stands the best chance among all active strategies, it does require investors to patiently hold their portfolios when it appears that other strategies are marching ahead. It's almost certain that at

Starting point is 00:40:25 some point, a focused portfolio will underperform the market, but over the long run, superior businesses will win. If you were to ask Buffett what his preferred holding period would be for stock, he would probably tell you that he would prefer to hold it forever, or as long as the company continues to generate above-average economic returns and management allocates the earnings of the company in a rational manner. One of the biggest benefits of holding forever or for a very long period of time, and I think this is often underappreciated is the enormous value of unrealized capital gains. Haxstrom says, quote, when a stock appreciates in price but is not sold, the increase in value is an unrealized gain.

Starting point is 00:41:08 No capital gains tax is owed until the stock is sold. If you leave the gain in place, your money compounds more forcefully. Overall, investors have too often underestimated the enormous value of this unrealized gain, what Buffett calls an interest-free loan from the Treasury, end quote. Both Buffett and Munger consider inactivity in portfolio management to be highly intelligent behavior because of this. Also, managing a focused portfolio requires you to think of the ownership of stocks as ownership in real businesses. You must be prepared to study the businesses you own to understand it very well. You need to have an investment time horizon of at least five years, you shouldn't use any leverage in your portfolio and learn how to detach your

Starting point is 00:41:54 emotions when investing in the stock market. Related to the emotional aspect, oftentimes the investor's worst enemy is not the stock market, but oneself. Someone could be very knowledgeable about mathematics, accounting, and finance, but if they haven't learned to master their emotions, then they probably don't have what it takes to be a great investor. Benjamin Graham said that having an investors' attitude is a matter of being prepared, both financially and psychologically, for the market's inevitable ups and downs. Not only knowing that downturns will inevitably happen, but to have the emotional fortitude to react appropriately when a downturn does occur. From Benjamin Graham's perspective, when a downturn occurs, you should react to an unattractive

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Starting point is 00:45:57 and expenses. This and other information can be found in the income funds prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. I find behavioral finance to be an interesting topic that is worth covering, so I'll touch on that a bit here. Overconfidence is the first investor bias I wanted to mention. If you ask the average person what their skills are on a particular topic, odds are more than 50% of people would tell you that their skills are above average. It's a natural human tendency for people to overestimate their ability to do things, investing included. Most investors are highly confident that they are smarter than everyone else, thus they have the tendency to overestimate their skills and knowledge.

Starting point is 00:46:42 Also, people tend to rely on information that confirms whatever it is they believe, and they also disregard any information that is contrary to their opinion. Overconfidence can lead to us making some really simplified and dangerous assumptions. This is why bubbles occur. People see that a stock has doubled over the past three months, so they think that trend must continue, and it's very likely that it will continue when in fact it's not. If you're applying Buffett's focused investor approach, my best advice to overcome overconfidence would be to thoroughly study whatever company it is you're looking to purchase. And make sure it checks all the boxes as far as the investment tenants go that I outlined earlier. This means reading the company's annual reports and taking a look at their

Starting point is 00:47:27 quarterly filings as well. If you're just getting started, in my opinion, it's probably a good idea to limit your individual stock picks to only be a small portion of your overall portfolio, say less than 5% or 10% of the total for beginners. This ensures that any mistakes you make won't substantially hurt your overall investment returns too much. The investor bias that Hagstrom says is the most difficult hurdle that prevents investors from successfully applying Buffett's approach to investing is loss aversion. Loss aversion is the human tendency to dislike the loss of capital more than the same

Starting point is 00:48:03 level of gain. According to a study by Daniel Conman, they were able to prove mathematically that people regret losses more than they welcome gains of the same size, up to two to two and a half times more, actually. In other words, the pain of a loss is far greater than the enjoyment of a gain. This loss aversion tends to make investors more conservative than they potentially should be in some cases. For example, someone who is in their 20s might have some portion of their portfolio allocated to bonds, even though bond yields are very low today and likely won't outperform stocks from now until they hit their retirement age because of the

Starting point is 00:48:41 long time horizon they have. I think that loss aversion also might keep people from investing in the stock market in general, even though you're very likely to make money in stocks if you have a five or 10 plus year time horizon. Many people look at what happened in 2000 or 2008 and think they can't afford to lose 30 or 40% of their money in stocks. So they end up just holding something that is perceived as safer, such as bonds or cash, even though they could make much more money just continually buying and holding stocks and not even checking their account balances over that time. It's important to remember that there will always be many days or even months where the stock market is down. But when you look at the data, the stock market is up 87% of the time

Starting point is 00:49:25 when held for a five-year period. Stocks are up 94% of the time when held for a 10-year period. So as you extend your time horizon, you increase your chances of of making money in the stock market. Even when looking at just a one-year period, stocks increase 74% of all years. But when you zoom into a single day, stocks are up 53% of the time. So it's essentially a coin flip day by day by day. So down days and down weeks are expected and are actually pretty common. And occasionally, quote unquote, losing money is to be expected. But when you hold stocks for a long period of time, it's likely you will end up making a good return on your Additionally, loss aversion might prevent someone from selling a stock that they know is a losing

Starting point is 00:50:10 company and actually realize their loss because it hurts to realize that loss even though that money could be allocated to a better company. Loss aversion also relates to what is called the disposition effect, which is the tendency to defer regret by holding onto losers and to avoid being greedy by selling our winners. Even worse would be to sell your winners to allocate to your losers and eventually you'll end up with a portfolio full of bad companies. The most powerful element in investing is time and you're wasting it by sticking with an investment strategy that isn't working. To me, this is one of the most difficult biases to overcome. On the one hand, you might see that a particular individual stock or asset class is overheated, so I can see the case

Starting point is 00:50:53 to sell your winners to rebalance. Additionally, the best performing investments tend to be the most volatile, so I can also see why selling when there is a bit of irrational exuberance can help you sleep better at night, because eventually there will be a big drawdown. You just don't really know when. And that's why I really like Warren Buffett's approach of not letting the irrational exuberance get the best of you. He's essentially playing a totally different game than most other investors. This reminds me of Warren Buffett's investment in Coca-Cola many years ago. In 1988, Buffett purchased $1 billion worth of Coca-Cola shares, and over the next 10 years, the price of the stock went up 10-fold while the S&P 500 went up by threefold.

Starting point is 00:51:37 You might be thinking that, hey, Coca-Cola must have been an easy pick. It was a very well-known brand, trading at a reasonable price, and it was growing at a pretty fast clip at the time. But over that 10-year period, Coca-Cola only outperformed the market during six of those 10 years. Based on loss aversion, this underperformance on four of those years would naturally lead to many people not wanting to own the stock. But given that Buffett had overcome this natural tendency, he was able to know what the true value of Coke was over that time and really take advantage of it, even when the market temporarily disagreed with his assessment. Buffett would continually

Starting point is 00:52:14 check in on the economic progress of the company and see that the overall company was doing an excellent job. So he just continued to own the business while everyone else would pay closer attention to the day-to-day price movements of the stock. So Buffett is stepping in and buying a great company at a fair price while a lot of investors are piling into the stock in the years that it's doing well and maybe even getting rid of the shares in the years that the stock isn't doing as hot. I'll end this part with a quote from Benjamin Graham, quote, The investor who allows himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage.

Starting point is 00:52:56 That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused by another person's mistakes of judgment, end quote. Next, I wanted to walk through a case study that Haxstrom laid out in chapter four of his book with real purchases that Buffett has made. The nine examples that Haxstrom walked through in his book were Washington Post, Geico, Capital Cities, ABC, Coca-Cola, General Dynamics, Wells Fargo, American Express, IBM, and Heinz. And it's important to keep in mind that Haxstrom's book, The Warren Buffett Way, was released

Starting point is 00:53:32 in 2013. I noticed that IBM and Hines ended up being complete duds for Buffett, so it just goes to show that even the best investors on the planet still make mistakes even after being in the game for so many decades. However, his investment in Apple in 2016 and Beyond has more than made up for such mistakes. Buffett first started buying IBM in 2011, initially having a $10.7 billion position. After six to seven years of declining revenues and a subpar stock performance, he then fully exited his position in IBM. In 2013, Buffett partnered with 3G Capital to buy Heinz for $23 billion. In 2013,

Starting point is 00:54:13 2015, Heinz merged with Kraft Foods, and since then, the stock is down nearly 50%. I didn't want to dive too much into these stock picks, but I did want to rewind back to 1988 to look at his purchase in Coca-Cola, as it's a company that all the listeners are familiar with to some degree. Like I mentioned earlier, in 1988, Berkshire purchased $1 billion worth of Coca-Cola shares, which at the time was a third of the Berkshire portfolio and 7% of the shares outstanding. Wall Street was quite surprised by this as the stock was trading at five times book value and 15 times earnings, which was a premium above the market at the time. Haxstrom deviated from the order of tenants I listed earlier, so I'm going to stick with

Starting point is 00:54:57 the order he presents in the book, so please bear with me. Tenant one, simple and understandable. The business of Coca-Cola is relatively simple as they purchase commodity inputs and mix these commodity inputs to manufacture concentrate that is then sold to bottlers. The bottlers then sell the finished product to retail outlets of all variations to get the product to the end consumer. The company also provides soft drink syrups to restaurants and fast food retailers. It doesn't take a rocket scientist to understand Coca-Cola's business model. Tenet two, consistent operating history. The business started in 1886 and today is selling the same beverage plus many others. Practically no business has been around longer than Coca-Cola.

Starting point is 00:55:42 They are the number one global provider of beverages ready to drink, coffees, and juices. So we got simple and understandable and consistent operating history. Check for both of those. Three, favorable long-term prospects. When Buffett had made his purchase, he had said that he was certain that in 10 years, Coca-Cola would be doing substantially more business than when he had originally purchased it. Buffett had obviously been aware of Coke his whole life as he sold Coke bottles as a kid and followed the company as an investor. The company performed poorly in the 1970s and underperformed the market, but during the 1980s,

Starting point is 00:56:20 Buffett saw that the leadership team had been pointing the ship in a much better direction. They brought in a new leadership team and Buffett recognized that they were taking intelligent risks, cutting costs, and optimizing their return on assets within each business unit. Tenant four, high profit margins. In 1980, Coca-Cola's pre-tax profit margins were a measly 12.9%, down from 18% in 1973. With the new CEO, Roberto Goizetta, his profit margins rose to 13.7%, and by 1988, when Buffett first purchased, the profit margins had risen to 19%. So profit margins were definitely heading in the right direction under the new leadership team. Tenet five, high return on equity. The new CEO clamped down and divested from any business unit that wasn't producing

Starting point is 00:57:09 an adequate return on equity. During the 1970s, the ROE was 20%, and in 1988, the ROE had risen to 31%. The high return on equity helped fuel positive stock performance during the 1980s, as the market value of Coca-Cola stock compounded by 19.3% per year from 1980 to 87. Tenant number six, candor. Candor isn't a term I hear often, so for those not familiar, it essentially means that managers are open, honest, and not trying to hide anything to the benefit of themselves. The CEO wrote to shareholders. We shall, over the next decade, remain totally committed to our shareholders and to the

Starting point is 00:57:52 protection and enhancement of their investment. In order to give our shareholders an above average total return on their investment, we must choose businesses that generate returns in excess of inflation." The leadership team knew that in order to increase the value of the company for the shareholders, he would need to increase profit margins and return on equity, as well as the dividends paid over time. All three of these, when Buffett purchased, were all trending in the right direction, so Roberto wasn't just talking a big game.

Starting point is 00:58:22 He actually had the proof in the performance of the business. In order to do so, he was cutting investments from areas that did it. provide an adequate return on investment, and redeploying that capital where he could earn a sufficient return. He wasn't pursuing growth just for the sake of growth. He was ensuring that the capital was being redeployed back into the business effectively, which at the time, the highest returns were to be found in the soft drink core business unit. Tenant seven, Rational Management. In addition to what I mentioned under the Kandor tenant previously, management was definitely taking the company in the right direction. In 1984, management announced that the company would

Starting point is 00:59:01 repurchase 6 million of their own shares of stock in the open market. This is always a benefit for shareholders, assuming that the stock is trading at a price that is below its estimated intrinsic value. Tenet 8. Each dollar retained must lead to at least a $1 increase in value. In 1973, owner's earnings were $152 million. In 1980, owners' earnings were $152 million. In 1980, owner's earnings were $262 million, which amounted to an 8% annual growth rate. From 81 through 88, owners' earnings grew from $262 million to $828 million, which is an average annual compounded growth rate of 17.8%. And this is before Buffett had purchased. This difference in the growth rate of the owner's earnings was clearly reflected in the growth rate of the stock price.

Starting point is 00:59:51 Haxtram outlines that from 73 to 82, the total return for shareholders was 6.3%. Then from 83 to 92, the total return was 31.3% annually. 10 at 9 and 10, the institutional imperative in calculating owner's earnings. When the CEO first entered the scene at Coke, his first move was to divest from businesses that weren't earning an adequate return and investing that capital where higher returns could be achieved, which was their core business of selling syrup. This is a great sign of resisting the institution. imperative, as many managers will invest in new segments or just go out and buy out their competitors just for the sake of growth of the top line revenue and make it look like they're

Starting point is 01:00:34 doing their job effectively. It was very telling that the new CEO went against what other managers would do in that situation and stick with what he knew would likely benefit long-term shareholders the most. Simply investing capital where the highest returns can be made sounds It's easy and it sounds simple, but who wouldn't want that? But it took a lot of mental fortitude for him to make that move as most of his competitors were doing the exact opposite in investing in unrelated businesses. For example, Anheiser-Busch was using their profits from selling beer to invest in theme parks. Pepsi bought snack businesses, free to lay in restaurants such as Taco Bell, KFC, and Pizza Hut. So from what I read, the new CEO and management team

Starting point is 01:01:17 were definitely resisting the institutional imperative and ignoring what other companies were doing. Tenet 11, determined the value. When Buffett purchased Coke, the company was trading at 15 times earnings and 12 times cash flow, which was a 30 and 50% premium to the market average. Buffett bought the company when it had a 6.6% earnings yield at a time when long-term bonds were yielding 9%. Just because Coca-Cola was yielding less than a long-term bond doesn't mean that the value isn't, significantly higher. As we all know, the value of stock is the projected future earnings for the

Starting point is 01:01:52 company discounted at an appropriate discount rate. In 1988, owners' earnings for Coke totaled 828 million and the 30-year U.S. Treasury yielded 9%. If you assume that the company had zero growth, you would just need to simply take 828 million and divide it by 9%, giving you a value of 9.2 billion. However, it would probably be foolish to assume that Coke wouldn't grow at all in the future, as earnings had grown at nearly 18% per year since 1981. In the book, Haxstrom takes a simple two-stage process to value Coke. He makes an assumption that Coke will be able to grow their cash flows for the next 10 years at 15% per year, then from year 11 onwards they would grow at 5% per year.

Starting point is 01:02:39 projecting out these cash flows and discounting them back to today, that would give you a valuation of $38.16 billion. This is far greater than the market valuation of $14.8 billion. Even if Coke only grew at 10% per year over the first 10 years, the estimated intrinsic value would be $32.5 billion. If they grew at 5%, it would be $20.7 billion. This isn't bad for a soft drink company. 10 at 12. Buy at attractive prices. At this point, you probably know that a strong margin of safety was built into the price that Buffett bought it at. A conservative valuation even had a 27% margin of safety built into the price, but the margin of safety was more likely to be over 50%. He acquired over 93 million shares at an average price of $10.96, which

Starting point is 01:03:29 represented 35% of Berkshire stock portfolio. Note that when Buffett does his intrinsic value analysis, he isn't really looking at the market price. He determines what he thinks the total value the company is and then comparing that against the price offered by the market. Buffett often said that price has nothing to do with value. Coca-Cola stock had done exceptionally well throughout the 80s, so this was definitely not a beaten-down stock that was totally ignored by the market. It was a top performer, or as Buffett would say, a great company that was trading at a fair price, or maybe even a great price in this case for Coke. To end this analysis on Coca-Cola, I wanted to read Hagerum's final paragraph about the company on page 110, quote,

Starting point is 01:04:14 The best businesses to own, says Buffett, is one that over a long period of time can employ ever larger amounts of capital at sustainably high rates of return. In Buffett's mind, this was the perfect description of Coca-Cola. Ten years after Buffett began investing in Coke, the market value of the company had grown from $25.8 billion to $14,000.4.4.4.4.4.4.4.5.4.5.2 Over that time period, the company produced $26.9 billion in profits, paid out $10.5 billion in dividends to shareholders, and retained $16.4 billion for reinvestment. For every dollar the company retained, it created $7.20 in market value. At the end of 1999, Berkshire's original $1.023 billion investment in Coca-Cola was worth $11.6 billion. The same amount in invested in the S&P 500 would be worth $3 billion, end quote.

Starting point is 01:05:10 All right, so that just goes to show how well Buffett did investing in Coca-Cola, and I hope you found this episode really helpful. We had a ton of information jam-packed into this episode, so I really hope you found it helpful. Sometimes it's good to just go back to the basics and help recognize some of our weak spots as an investor. And I found a lot of good insights going back through Buffett's investment principles, all thanks to Robert Haxstrom and his great book,

Starting point is 01:05:35 the Warren Buffett way. If you found this episode helpful, I would love it if you could just do me a quick favor and simply share this episode with one of your friends who you think might find it helpful as well. This will really help support and grow the show so we can continue to provide great content for you all for the years to come. I really appreciate you tuning in. I had a lot of fun putting together this episode, so I really hope you enjoyed it. So with that, we'll see you again next week. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com.

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We Study Billionaires - The Investor’s Podcast Network - TIP487: Warren Buffett’s 12 Investment Principles (with a Case Study)

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