THE ESSAYS OF WARREN BUFFETT - Buffett Powerful Philosophy for Investing

Published:    March 28, 2001

THE ESSAYS OF WARREN BUFFETT by, Joseph Dancy - LSGI Technology Venture Fund
		Living quiet, unpretentious lives Mr. and Mrs. Othmer - a professor of chemical engineering and a former teacher - died a few years ago in their nineties. When the Othmer's died, friends were shocked to learn that their estate was worth $800 million. The Othmer story is not unique. Anne Scheiber never married and worked for the government, never making more than $4,000 a year. She lived a quiet, simple life. When she died in 1995, her estate was worth $22 million. Likewise, Jacob Leeder lived in a modest home and drove a 1984 Oldsmobile station wagon. Occasionally he would go out to eat - usually at a cheap, cafeteria- style restaurant. It wasn't until Leeder died last year that friends discovered that he was worth $36 million. How did these people get so rich? Like many long term investors, they put their money into well managed undervalued companies and left it there. The Othmers had an additional benefit: in the early 1960s they each invested $25,000 with Warren Buffett. Today Mrs. Othmer's shares are worth $578 million; her husband's, sold on his death when the price was lower, were worth $210 million. Even without Mr. Buffett, if they had put their funds into the broader market they still would have done well - having an estate with a current value of between $50 million and $100 million. The Essays of Warren Buffett The investment strategies utilized by Warren Buffett to attain the Othmer's gains were recently published by a law professor at Cardozo University. Entitled "The Essays of Warren Buffett: Lessons for Corporate America" it is a compilation of Buffett's annual reports and other communications, and is a good overview for those not familiar with his investment philosophy (available by sending $17.45 to Prof. Lawrence Cunningham, Cardozo University, 55 Fifth Ave., New York, NY 10003). Some of Buffett's more interesting investment philosophies are as follows: 1. Buy a Good "Business Boat" Buffett points out the importance of choosing a company situated in a growing and profitable industry. He identifies his largest investment mistake - buying the company his firm was named after (Berkshire Hathaway) - not because the company was flawed, but because the industry it was in (textiles) was so unattractive. Buffett recalls how the textile industry provided very meager returns for Berkshire. No matter how well managed the company was it would always have subnormal returns. The textile industry was a commodity business, competitors had facilities located overseas that were low cost producers, and substantial excess capacity existed worldwide. Buffett claims he would not close down a business that is important to a community just to improve the corporate rate of return, but if it appeared that losses would be unending no other course of action makes rational economic sense. Buffett notes "a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row . . . Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks." 2. Compound Returns by Deferring Taxes One reason that the Othmer's were able to accumulate $800 million in assets was because their investment in Berkshire stock compounded and their capital gains taxes were never realized. "Tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate. But I suspect many Berkshire shareholders figured that out long ago" according to Buffett. Illustrating the point he notes "imagine that Berkshire had only $1, which we put in a security that doubled by year end and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years . . . we would be left with $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times in 20 years . . . we would be left with about $692,000." Buffett's calculations use a capital gains tax rate of 34% - much higher than today's, but the point is well taken. Deferred taxes allow an investment to compound, increasing the return on investment. 3. Concentration of Investments Professor Cunningham notes that "contrary to modern finance theory, Buffett's investment knitting does not prescribe diversification. It may even call for concentration . . . a strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor's thinking about a business and the comfort level he must have with its fundamental characteristics before buying it." Other articles have noted the tendency of Buffett to concentrate his investments, and claim that this is part of his success. If nothing else, concentration allows an investor to follow a company much more closely - which allows them to better judge when a stock is undervalued. 4. Good Business Judgment & Mr. Market Buffett subscribes to the theory that the market is not always efficient, and that at certain times companies will be grossly undervalued or overvalued. The market allows an astute investor to buy positions in companies well below intrinsic values. In the long term, such value will be recognized. "An investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace . . . The speed at which a business's success is recognized is not that important as long as the company's intrinsic value is increasing at a satisfactory rate - in fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price." 5. Small Base From Which to Grow Due to the size of the funds Berkshire now manages, Buffett recognizes that the return he will obtain from his investments will be lower than when he was managing much smaller sums. Using analogies to the growth of bacteria, he notes that growth from a small base can continue at a much faster pace for much longer than from a large base. The larger sums now being managed limit the size of companies Berkshire can invest in - using a concentrated investment approach meaningful investments in small and micro-cap companies cannot be made from a practical standpoint. Summary Those who are familiar with Buffett's investing style, or who have read some of the books on him published recently or the Berkshire annual reports, will find little new here. Even so, it is always interesting to read the thoughts and investment strategies of one of the world's most successful investors. http://www.marketocracy.com/cgi-bin/WebObjects/Portfolio.woa/wa/ArticleViewPage?source=IdKnEfOoDlLlKcDcMaKiAbLb