Investment process
Thinking for yourself
After Ben Graham, the person who had the most influence on Warren Buffett was Philip Fisher. Buffett says: “After exposure to Fisher and Charlie, I started looking for better companies. Previously I was doing both. Now we are looking for good companies, not just cheap companies.”
In time Buffett admitted that the stocks he was buying were entirely different from those that Graham would buy. What he had retained from Graham was ‘the proper temperamental set’ – that is, the principle of buying value, the conservatism embedded in Graham’s margin of safety principle, and the attitude of detachment from the daily market gyrations.” (Lowenstein, Buffett, The Making of an American Capitalist, 1995,2008)p.201. (emphasis added)
Philip Fisher
Philip Fisher wrote three books. His book, Conservative Investors Sleep Well, written in 1974 at the depths of the bear market and published by Harper & Row in 1975 and republished by John Wiley & Sons, Inc. in 1996, notes that: “Unfortunately, often there is so much confusion between acting conservatively and acting conventionally that for those truly determined to conserve their assets, this whole subject needs considerable untangling…” (Fisher, 1974,1996)p.178 (emphasis added) He points out that for investors able to think for themselves and act independently the investors’ approach can be conservative regardless of whether it is conventional or unconventional.
Conservative vs conventional
This crucial distinction between conservative and conventional is explained by Warren Buffett in one of his letters to his investors in the 1960s. Buffett commented on the failure of the average mutual fund to outperform the indexes. As reported by Roger Lowenstein: “Why was it, [Buffett] wondered, that “the high priests of Wall Street,” with their brains, training, and high pay, couldn’t top a portfolio managed by no brains at all? He found the culprit in the tendency of managers to confuse a conservative (i.e., reasonably priced) portfolio with one that was merely conventional.”
Lowenstein elaborates, “It was a subtle distinction, and bears reflection. The common approach on owning a bag full of popular stocks – AT&T, General Electric, IBM, and so forth – regardless of price, qualified as the latter, but surely not as the former. Buffett blamed the committee process and group-think that was prevalent on Wall Street.” (Lowenstein, 1995,2008)p.85.
The irony of buying these stocks ‘regardless of price’ is that they are Mr. Market and this is what causes prices and value to get out of whack. That is, these conventional stocks are usually either fully priced or overpriced.
Household names
In the era Lowenstein is referring to, no money manager would ever be criticised for investing in these companies. They were the bluest of blue chips. They were household names. The same types of companies exist today in all countries.
I have a fairly dim view of household name companies. Frequently (not always) they are run by career executives who are part of the old boys’ network. As Stephen Jarislowsky, dean of Canadian investment managers puts it: “The board, made up mainly of friends (cronies) of management, was normally there to do no more than rubber stamp the decisions of management, and the participation of many of the directors was pretty negligible.” (Jarislowsky, 2005)p.62.
Conventional money managers
A lot of money managers invest conventionally. After referring to the exceptional investment records of the likes of John Templeton, George Soros and Warren Buffett, Peter Lynch writes: “These notable exceptions are entirely outnumbered by the run-of-the-mill fund managers, dull fund managers, comatose fund managers, sycophantic fund managers, timid fund managers, plus other assorted camp followers, fuddy-duddies, and copycats hemmed in by the rules. You have to understand the minds of the people in our business. We all read the same newspapers and magazines and listen to the same economists. We’re a very homogeneous lot, quite frankly.” (Lynch, One Up on Wall Street, 1989,1990)p.40
As John Maynard Keynes put it succinctly in The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes, 1936,2007)p.158.
Lessons for investors
Think for yourself and do not be afraid to invest conservatively even if the company seems an unconventional choice. To invest conservatively you have to find superb companies and buy them at very advantageous prices, that is, with a Margin of Safety. You have to satisfy yourself it’s a superb company and not just blindly choose a household name company. Here’s a good checklist of what to look for:
Robert Hagstrom has gone back and reviewed all of Buffett’s purchases through 1994 and looked for commonalities to try to discern the basic principles or what Hagstrom calls the tenets of companies Buffett invests in. He considers what Buffett has said and what he has done and made a list of ten tenets. (Hagstrom, The Warren Buffett Way, 1994) p.75.
1. The business is simple and understandable. The investor should understand the business’ products and services and how the business operates: its revenues, expenses, cash flow, labor relations, pricing flexibility and capital needs.
2. The business has been profitably producing the same product or services for years and not be facing major business changes. The business should not be in turn around mode.
3. The business has an established franchise, meaning a product or service that is needed or desired, has no close substitute and is not regulated. The ability to regularly raise prices is one of the defining characteristics of a franchise. This established franchise quality has also been called a ‘moat’.
4. How management deals with the cash produced by the business in excess of the needs of its existing business. This is the issue of capital allocation, reinvestment in the growth of the business/business expansion and dividend and share-buyback policies. On the positive side this involves investing the Free Cash Flow or excess capital to earn returns to the company well in excess of its cost of capital. On the downside, it avoids companies where management is investing internally at low rates of return or buying back shares at high prices to juice earnings per share without increasing net earnings.
5. Management that unfailingly thinks and behaves like an owner of the business and has the courage and candor to discuss failures openly in reports to shareholders.
6. Management that have the courage to resist what Buffett calls the institutional imperative. This is the lemming like tendency of management to imitate their peers in other companies. According to Buffett the institutional imperative exists when an institution resists change, when corporate projects materialize to soak up available funds, when the leader’s cravings, however foolish, are supported by rate-of-return and strategic studies created by his troops, when expansion, acquisitions and executive compensation mindlessly imitate peer companies.
7. The business focus is to produces a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
8. The business produces substantial Owner Earnings described by Buffett to be traditionally calculated cash flow less the capital expenditures and additional working capital that may be needed.
9. The business has comfortable profit margins and a culture of continuously cutting cost.
10. The business has favorable long term prospects such that retained earnings can be used advantageously to create shareholder value
Readers wishing to dig more deeply into the subject of the best companies to invest in can look at Part 6: The Hallmarks of Superb Businesses
And see Chapter 31. General approach to choosing common stocks
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