Displaying their ignorance
Many investors think of Warren Buffett as a classic value investor. They are wrong. It will clarify your thinking to view him simply as an investor.
Dividing the investing world into value stocks and growth stocks is a product differentiation foisted on investors by the investment industry like growth and value factor ETFs and index producers like Russell, with growth and value indices. Dividing investors into value investors and growth investors is a recipe for muddled investment thinking.
Displaying their ignorance, not their sophistication
Warren Buffett is reported by The Economist magazine in its February 2, 2013 edition to have said: “Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.”
Buffett wrote years ago:
“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a ‘value’ purchase.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America, Cunningham 1998) p85. (Buffett 1998) (emphasis added)
A few further quotes from Warren Buffett will be useful. This next one is easily misunderstood. For a long time I thought it meant that Buffett was content with slow growth companies. Read the following and then I will explain what I think it means:
Importance of high ROE
“The primary test of managerial economic performance is the achievement of 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. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.”
One can ask whether one would rather own a company that earns a dollar for every five dollars of equity capital, i.e. a return on equity capital of 20%, year after year and grows the earnings per share slowly, or one that earns a return on equity capital of 5%, but increases its earnings per share by, say, 15% each year. The question for the second company would be, ‘how do they manage to do it?’ and ‘If the company cannot earn its cost of capital, how does it survive?’” (Buffett, 1998) p170. (emphasis added)
As an aside, ratios like ROE, ROC and ROCE are becoming misleading in a world of intangibles. See here.
It was his seeming preference for a company that “grows the earnings per share slowly” that mislead me. What he is actually saying is companies that produce a high return on equity capital (ROE) will produce excess capital that can be invested to grow the company. What he is criticizing is analysts who focus on consistent gains in earnings per share to the exclusion of all else. The reality is that management can milk a company to produce apparently consistent earnings growth (for a time) to please analysts, while at the same time running it into the ground. Think here of GE.
Exceeding cost of capital
Buffett uses the term cost of capital. Companies’ capital is comprised of both debt and equity. The cost of debt is easy to understand. It’s a matter of determining the rate of interest paid on its debt. There is also a cost of equity. This is less simple both to define and calculate. In effect it is established by the market. It is based on the return investors require from the common shares of a company and reflects the quality/riskiness of company. A company that is less risky has a lower cost of equity than a more risky company. The cost of capital of a company is thus calculated based on a blending of its cost of debt and cost of equity. This explanation should suffice for present purposes.
Beguiling consistent growth in earnings
Buffett’s observation that managements and financial analysts put too much emphasis on consistent growth in earnings is profound. In some investor’s minds everything turns on earning per share growth. It is thought to justify high price earnings ratios. Many investors overpay for what they see as a company that grows its earnings substantially from year to year. The germane question is: “how do they manage to do it?”
As a further aside, price earnings ratios are not the best way to value companies. See here.
Joined at the hip
In discussing the two customary approaches to investing ‘value’ and ‘growth’ Buffett confesses to earlier fuzzy thinking and says:
“In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid?” (Buffett, 1998) p85. (emphasis added)
In Robert Hagstrom’s book, The Warren Buffett Way, the author suggests that “what Buffett learned from Graham was that successful investing involved the purchase of stock when the market price of those stocks was at a significant discount to the underlying business value.” Hagstrom quotes a talk given in 1984 by Buffett at Columbia University in which “Buffett explained that there is a group of successful investors who acknowledge Ben Graham as their common intellectual patriarch. Graham provided the theory of margin of safety, but each student, noted Buffett, has developed different ways to apply this theory to determine a company’s business value. (Hagstrom, 1994) p46.
This is all true. But, it is not the whole story and can mislead if taken in isolation.
Pure Ben Graham investing is what Warren Buffett calls picking up cigar butts. You get them free but there are only a few puffs left in them.
Hagstrom posits correctly that Buffett’s education as an investor was a synthesis of “two distinct investment philosophies”: those of Ben Graham and Philip Fisher. (Hagstrom, 1994) p27. Hagstrom quotes from a 1987 Forbes article written by Buffett titled “What we can learn from Philip Fisher”. Buffett read Fisher’s 1958 book, Common Stocks and Uncommon Profits (Harper & Brothers) and sought out Fisher. Buffett wrote in the article: “When I met him, I was as impressed by the man as by his ideas.” He went on: “Much like Ben Graham, Fisher was unassuming, generous in spirit and an extraordinary teacher.” Buffett added that even though Graham and Fisher’s investment approach differed, they “parallel in the investment world.”
So, what is Buffett’s investment style? I will try to describe it using, as far as possible, his own words.
Buffett’s approach to investing
His style reflects his investing aims, which are, very simply to: “Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, 1998) p93. (emphasis added)
His style is thus to identify companies that achieve that end and buy them at ‘a very attractive’ price. (Buffett, 1998) p85. Note, he does not require that they march steadily upward. There is a normal lumpiness to the earnings of even the best companies. The only earnings that grow steadily are those that are ‘managed’ by the CEO and CFO. The ‘very attractive price’ is to provide a margin of safety.
As the size of Berkshire Hathaway has increased, Buffett has had to reduce his standards on margin of safety which has, in turn, impacted his investment returns. As he puts it: “We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett, 1998) p85.
Unless you are running a massive portfolio like Berkshire, you can still insist on ‘very attractive’ prices.
I think it best to avoid putting Warren Buffett into nice investing style categories. It’s far better to truly learn how he goes about investing.
There are many investing styles. The more we learn, the more we can avoid approaches that just don’t work.
Some of the various styles can be described fairly simply. As to what they really mean is another question. The styles may be described as: buying great companies; buying growth companies; buying companies cheap; buying strong stock performers; buying steady stock performers; buying small companies; buying big companies; buying fallen stars; buying great companies cheap and so on. There are fundamental differences between these styles. There are also fundamental misconceptions as to what the styles really are.
To read further about the styles and their strengths and weaknesses take a look at Chapter 25. Investment styles
The different topics and styles discussed are in these Sections:
25.12 The big non-cyclical growth stocks
25.13 Copying Berkshire Hathaway
25.16 Value Investing and value stocks
25.17 Computer based value factor investing and smart beta
25.19 The investing style of the great investors
25.24 Conclusion regarding investment styles and core principles
Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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