Buffett, What is Your Secret?
If you had the chance to interview Warrenhow to make an essay longer period trick Buffett, the chairman and CEO of Berkshire Hathaway, what would you ask? When you know where to look, you may be surprised to find that he has already answered most of your questions. If I were to interview him, I would like it to take place in Gorat’s Steak House in Omaha, Nebraska, Buffett’s favourite place to eat. As he does every time, he orders a rare T-bone, a double order of hash browns, three cherry cokes, and follows with a chocolate ice-cream sundae.
The following is a transcript of my imaginary interview.
John Price: Mr Buffett, before I ask you about your investing secrets, can you tell me about your track record?
Warren Buffett: It depends how far you want to go back. To keep it simple, I’ll just describe it since my start with Berkshire Hathaway. Back in the 1960s it was an established textile company. I bought my first shares in the business for $7.50 on Wednesday, December 12, 1962, and on Tuesday, December 11, 2007, almost exactly
WB: This is an average annual return of over 24 percent.
JP: Remarkable. What happened next?
WB: The price tumbled to a low of $70,050 on Thursday, March 5, 2009. But today it is back around $125,000. This means approximately an average of 22.5 percent per year over more than 47 years.
JP: So this is an example when the share price more than halved. Has this ever happened before?
WB: I recall it happened in 1974, in 1987, and again in 1998. Each time, like a punch-drunk
JP: Why is that?
WB: It does not matter what make essays longer company you are talking about, when the underlying business is strong and growing, such swings in the price just give the opportunity of buying more shares at bargain prices, something
JP: I get it. Look for quality businesses but only buy when their prices are lower than usual. But what is your secret in picking companies that are strong and growing in the first place?
WB: [Laughing] It is not really a secret since I describe the most important points every
JP: But tell us anyway.
WB: For a start the businesses must have [at this stage Buffett pulled out a copy of the latest annual report of Berkshire Hathaway and read] “demonstrated consistent earning power. Future projections are of no interest
JP: That’s interesting. There seems to be two points here. The first is that at least the earnings have to be positive and the second is that they should be growing in a consistent way. I did some research on the Australian market and found that only 37 percent of companies made a profit over the last 12 months. Putting it another way, well over 1,100 companies did not make a profit for their shareholders, their real owners.
WB: It is the similar in the US. Even on the New York Stock Exchange, NASDAQ and the American
JP: Can you give me an example?
WB: Sure. Consider Berkshire. Since 1996 earnings per share have grown by a multiple of around 3.7 and the price has grown by about the same amount. This correlation may vary a little for other companies, and it may be different when a company pays out a high proportion of its earnings as dividends. But over time good growth in earnings means good growth in price.
JP: But how can we have this confidence about the growth of earnings of other companies on the stock market or in other countries?
WB: It doesn’t matter where you are. As I said, the past growth of earnings has to be consistent. This consistency in the growth shows that management understands their business. They are able to build
JP: To measure this consistency I developed a function called STAEGR® which stands for stability of earnings growth. It measures the stability of earnings growth with more emphasis on recent years. Using
WB: That sounds useful. In
JP: What else do you look for?
WB: Two more important criteria are [reading from the report] “Businesses earning good returns on equity while employing little or no debt.”
JP: Let’s start with return on equity. Why should we choose companies where this is high?
WB: Return on equity is the earnings of a company divided by its equity. It is a measure of management’s ability to use the equity available to it. Think of it as part of management’s scorecard. If they are only earning a few percent on the equity of the business, that is the most that you can expect. Overall we want companies that have return on equity of at least 15 percent. After all, presumably you want to earn at least this amount
JP: When you put it like that it makes sense. What about debt? WB: Debt is a four-letter word around Berkshire. Last year I wrote that “we use debt sparingly. We will reject interesting opportunities rather than over-leverage our balance sheet. [We would never trade] a good night’s sleep for a shot at a few extra percentage points of return.” This is the debt of Berkshire. But it is the same when we are investing in companies. We just don’t want to be involved in companies with high debt.
JP: But don’t some companies need high levels of debt?
WB: There are two types of debt, discretionary and nondiscretionary, and they are both dangerous if they are too high. Apart from start-ups, nondiscretionary debt is when the company needs extra capital to maintain its
JP: We had some really extreme cases in Australia. For example, the debt to equity ratio of Babcock and Brown in December 2007 was 450 percent. Within months the company was in serious trouble and eventually it folded. I carried out a study on stocks on the ASX. It showed that companies that had debt to equity below 50 percent outperformed companies that had debt to equity above 50 percent by an average of 6.75 percent per year.
WB: I am not surprised. Getting rid of stocks with a high debt is part of the process of turning a speculative, low performing portfolio into one that is stable and high-performing.
JP: What about qualitative requirements?
WB: The first of these is to stay within your own circle of competence. Some time back I said, “The most important thing in terms of your circle of competence is not how large the area of it is, but how well you have defined the perimeter.” Investing in companies that you don’t understand or don’t support their
JP: I have heard you talk about economic moats. What are they and what role do they play?
WB: Just like castles had moats around them for protection, then ideal companies have moats
JP: So far it looks like your
WB: These are the main points and provide a good start.
JP: But when I find these companies, how do I know how much to pay? I have heard you say that you can pay too much for even the best of companies.
WB: [Scraping the last of the chocolate sauce from his bowl] That’s right. People do a whole lot of work finding ideal companies and then go and pay prices that make it almost impossible to make a profit.