Growth Stocks

How to select growth stocks?

Selecting growth stocks can be a challenging task, but there are a few key factors to consider when evaluating potential investments. Here are a few strategies that may help you identify growth stocks:

Look for companies with strong revenue and earnings growth: Companies that have consistently grown their revenues and earnings over time are more likely to continue growing in the future. Look for companies with strong revenue and earnings growth rates, and compare them to industry averages.

Look for companies with a competitive advantage: Companies that have a sustainable competitive advantage, such as a strong brand, proprietary technology, or a large market share, are more likely to continue growing in the future.

Look for companies with a solid management team: A strong management team is essential for a company's long-term growth. Look for companies with a track record of success and a clear vision for the future.

Look for companies in growing industries: Companies that operate in growing industries, such as technology, healthcare, or renewable energy, are more likely to benefit from long-term growth trends in those industries.

Look at valuation metrics: Growth stocks tend to trade at higher valuations than value stocks, so it's important to consider a company's price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, and other valuation metrics to ensure that you are getting a good deal.

Do your own research: It's important to conduct thorough research on the companies you are considering investing in. Look at their financial statements, management team, and industry trends to identify companies with strong fundamentals and growth potential.

It's worth noting that past performance is not a guarantee of future results and that investing in the stock market carries risk. It's always good to do your own research, invest in a diverse set of assets, and have a well-defined investment strategy that aligns with your financial goals.

What are the risks of investing in growth stocks?

Investing in growth stocks can be a great way to achieve strong returns, but it also comes with certain risks. Here are a few of the risks to consider when investing in growth stocks:

High Valuation Risk: Growth stocks tend to trade at higher valuations than value stocks, so there's a risk that the stock's price may not be justified by the company's fundamentals. High valuation can lead to a stock to be overpriced and may result in disappointment in future returns.

Earnings Risk: Growth stocks often have high expectations for earnings growth, which means that if a company misses its earnings estimates, its stock price may drop. This can be especially true for companies that have high P/E ratios.

Industry Risk: Companies that operate in a specific industry are subject to the risks of that industry. For example, companies in the technology sector are subject to rapid technological change, while companies in the healthcare sector may be subject to changes in government regulations.

Interest rate Risk: Growth stocks are sensitive to changes in interest rates, as they are more reliant on future earnings than current dividends. When interest rates rise, the value of future earnings may decrease, causing the stock price to fall.

Concentration Risk: Investing in a small number of growth stocks can lead to concentration risk, which means that if one of the stocks in your portfolio performs poorly, it can have a significant impact on your overall returns.

Political and Economic Risk: Political and economic events such as war, natural disasters, and changes in government policies can also impact a growth stock's performance.

It's important to keep in mind that investing in growth stocks carries a higher level of risk than investing in value stocks. It's important to diversify your portfolio, do your own research and have a well-defined investment strategy that aligns with your financial goals and risk tolerance.

The preferred stocks to own - Growth Stocks at suitable prices. Do not overpay to own them.

The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others.

The choice between the attractive issue that turns out well and the one that does poorly is by no means easy to make in the growth-stock field.

However, superior results may be obtained in this field if the choices are competently made.  

Even with careful selection, some of the individual issues may fare relatively poorly. 

Investing: how small UK companies can boost your wealth

Paul Marriage, manager of the Cazenove UK Smaller Companies Fund, tells Robert Miller why investors should ignore the 'noise' of macro economic news and look at smaller and profitable companies in the UK.

http://www.telegraph.co.uk/finance/financevideo/yourmoneytheirhands/9100964/Investing-how-small-UK-companies-can-boost-your-wealth.html

Be careful with companies in formation - Wait For Earnings

Without Earnings, Nothing To Measure

Graham was suspicious of 'hot' or fast-growth stocks because their promise relies on the prediction of ever-increasing future earnings with little historical evidence that the company can consistently produce ever-rising future earnings.

He warned the growth stock investor to seek two things:

• Assurance that growth will continue
• Assurance that the investor isn't paying too high a price for future growth.

Peter Lynch warns investors to be especially careful with companies in formation.  "Wait for earnings," he cautions.

• Though Lynch has done very well with some initial public offerings in particular (he was an original investor in Federal Express, "I'd say three out of four have been long-term disappointments."

Venture capital operations

Many high-tech, bio-tech or other emerging technology companies operate more like venture capital operations.

Venture capitalists demand guarantees of high returns because the risk is high that earnings will be slow in arriving, or will never materialize at all.

The venture capitalist is betting on a technology and the talent to put that technology into use.

Venture capital investment is best practiced by those who know a particular industry extremely well.

Characteristics of Growth Companies and their Value Drivers

Characteristics of growth companies

            Growth companies are diverse in size, growth prospects and can be spread out over very different businesses but they share some common characteristics that make an impact on how we value them. In this section, we will look at some of these shared features:

1. Dynamic financials: Much of the information that we use to value companies comes from their financial statements (income statements, balance sheets and statements of cash flows). One feature shared by growth companies is that the numbers in these statements are in a state of flux. Not only can the numbers for the latest year be very different from numbers in the prior year, but can change dramatically even over shorter time periods. For many smaller, high growth firms, for instance, the revenues and earnings from the most recent four quarters can be dramatically different from the revenues and earnings in the most recent fiscal year (which may have ended only a few months ago).
2. Private and Public Equity: It is accepted as conventional wisdom that the natural path for a young company that succeeds at the earliest stages is to go public and tap capital markets for new funds. There are three reasons why this transition is neither as orderly nor as predictable in practice. The first is that the private to public transition will vary across different economies, depending upon both institutional considerations and the development of capital markets. Historically, growth companies in the United States have entered public markets earlier in the life cycle than growth companies in Europe, partly because this is the preferred exit path for many venture capitalists in the US. The second is that even within any given market, access to capital markets for new companies can vary across time, as markets ebb and flow. In the United States, for instance, initial public offerings increase in buoyant markets and drop in depressed markets; during the market collapse in the last quarter of 2008, initial public offerings came to a standstill. The third is that the pathway to going public varies across sectors, with companies in some sectors like technology and biotechnology getting access to public markets much earlier in the life cycle than firms in other sectors such as manufacturing or retailing. The net effect is that the growth companies that we cover in chapter will draw on a mix of private equity (venture capital) and public equity for their equity capital. Put another way, some growth companies will be private businesses and some will be publicly traded; many of the latter group will still have venture capitalists and founders as large holders of equity.
3. Size disconnect: The contrast we drew in chapter 1 between accounting and financial balance sheets, with the former focused primarily on existing investments and the latter incorporating growth assets into the mix is stark in growth companies. The market values of these companies, if they are publicly traded, are often much higher than the accounting (or book) values, since the former incorporate the value of growth assets and the latter often do not. In addition, the market values can seem discordant with the operating numbers for the firm – revenues and earnings. Many growth firms that have market values in the hundreds of millions or even in the billions can have small revenues and negative earnings. Again, the reason lies in the fact that the operating numbers reflect the existing investments of the firm and these investments may represent a very small portion of the overall value of the firm.
4. Use of debt: While the usage of debt can vary across sectors, the growth firms in any business will tend to carry less debt, relative to their value (intrinsic or market), than more stable firms in the same business, simply because they do not have the cash flows from existing assets to support more debt. In some sectors, such as technology, even more mature growth firms with large positive earnings and cash flows are reluctant to borrow money. In other sectors, such as telecommunications, where debt is a preferred financing mode, growth companies will generally have lower debt ratios than mature companies.
5. Market history is short and shifting: We are dependent upon market price inputs for several key components of valuation and especially so for estimating risk parameters (such as betas). Even if growth companies are publicly traded, they tend to have short and shifting histories. For example, an analyst looking at Google in early 2009 would have been able to draw on about 4 years of market history (a short period) but even those 4 years of data may not be particularly useful or relevant because the company changed dramatically over that period – from revenues in millions to revenues in billions, operating losses to operating profits and from a small market capitalization to a large one. 

While the degree to which these factors affect growth firms can vary across firms, they are prevalent in almost every growth firm.

Growth companies- Value Drivers

Scalable growth

The question of how quickly revenue growth rates will decline at a given company can generally be addressed by looking at the company's specifics – the size of the overall market for its products and services, the strength of the competition and quality of both its products and management.  Companies in larger markets with less aggressive competition (or protection from competition) and better management can maintain high revenue growth rates for longer periods.

            There are a few tools that we can use to assess whether the assumptions we are making about revenue growth rates in the future, for an individual company, are reasonable:

1.     Absolute revenue changes: One simple test is to compute the absolute change in revenues each period, rather than to trust the percentage growth rate. Even experienced analysts often under estimate the compounding effect of growth and how much revenues can balloon out over time with high growth rates. Computing the absolute change in revenues, given a growth rate in revenues, can be a sobering antidote to irrational exuberance when it comes to growth.

2.     Past history: Looking at past revenue growth rates for the firm in question should give us a sense of how growth rates have changed as the company size changed in the past. To those who are mathematically inclined, there are clues in the relationship that can be used for forecasting future growth.

3.     Sector data: The final tool is to look at revenue growth rates of more mature firms in the business, to get a sense of what a reasonable growth rate will be as the firm becomes larger.

In summary, expected revenue growth rates will tend to drop over time for all growth companies but the pace of the drop off will vary across companies.

Sustainable margins

To get from revenues to operating income, we need operating margins over time. The easiest and most convenient scenario is the one where the current margins of the firm being valued are sustainable and can be used as the expected margins over time. In fact, if this is the case, we can dispense with forecasting revenue growth and instead focus on operating income growth, since the two will be the equivalent. In most growth firms, though, it is more likely that the current margin is likely to change over time.

            Let us start with the most likely case first, which is that the current margin is either negative or too low, relative to the sustainable long-term margin. There are three reasons why this can happen. One is that the firm has up-front fixed costs that have to be incurred in the initial phases of growth, with the payoff in terms of revenue and growth in later periods. This is often the case with infrastructure companies such as energy, telecommunications and cable firms. The second is the mingling of expenses incurred to generate growth with operating expenses; we noted earlier that selling expenses at growth firms are often directed towards future growth rather than current sales but are included with other operating expenses. As the firm matures, this problem will get smaller, leading to higher margins and profits. The third is that there might be a lag between expenses being incurred and revenues being generated; if the expenses incurred this year are directed towards much higher revenues in 3 years, earnings and margins will be low today.

            The other possibility, where the current margin is too high and will decrease over time, is less likely but can occur, especially with growth companies that have a niche product in a small market. In fact, the market may be too small to attract the attention of larger, better-capitalized competitors, thus allowing the firms to operate under the radar for the moment, charging high prices to a captive market. As the firm grows, this will change and margins will decrease. In other cases, the high margins may come from owning a patent or other legal protection against competitors, and as this protection lapses, margins will decrease. 

            In both of the latter two scenarios – low margins converging to a higher value or high margins dropping back to more sustainable levels – we have to make judgment calls on what the target margin should be and how the current margin will change over time towards this target. The answer to the first question can be usually be found by looking at both the average operating margin for the industry in which the firm operates and the margins commanded by larger, more stable firms in that industry. The answer to the second will depend upon the reason for the divergence between the current and the target margin. With infrastructure companies, for instance, it will reflect how long it will take for the investment to be operational and capacity to be fully utilized.

Quality Growth

A constant theme in valuation is the insistence that growth is not free and that firms will have to reinvest to grow. To estimate reinvestment for a growth firm, we will follow one of three paths, depending largely upon the characteristics of the firm in question:

1.     For growth firms earlier in the life cycle, we will adopt the same roadmap we used for young growth companies, where we estimated reinvestment based upon the change in revenues and the sales to capital ratio.

Reinvestment_t = Change in revenues_t/ (Sales/Capital)

The sales to capital ratio can be estimated using the company's data (and it will be more stable than the net capital expenditure or working capital numbers) and the sector averages. Thus, assuming a sales to capital ratio of 2.5, in conjunction with a revenue increase of $ 250 million will result in reinvestment of $ 100 million.  We can build in lags between the reinvestment and revenue change into the computation, by using revenues in a future period to estimate reinvestment in the current one.

2.     With a growth firm that has a more established track record of earnings and reinvestment, we can use the relationship between fundamentals and growth rates that we laid out in chapter 2:

Expected growth rate in operating income = Return on Capital * Reinvestment Rate + Efficiency growth (as a result of changing return on capital)

In the unusual case where margins and returns and capital have settled into sustainable levels, the second term will drop out of the equation.

3.     Growth firms that have already invested in capacity for future years are in the unusual position of being able to grow with little or no reinvestment for the near term. For these firms, we can forecast capacity usage to determine how long the investment holiday will last and when the firm will have to reinvest again. During the investment holiday, reinvestment can be minimal or even zero, accompanied by healthy growth in revenues and operating income.

With all three classes of firms, though, the leeway that we have in estimating reinvestment needs during the high growth phase should disappear, once the firm has reached its mature phase. The reinvestment in the mature phase should hew strictly to fundamentals:

Reinvestment rate in mature phase = 

In fact, even in cases where reinvestment is estimated independently of the operating income during the growth period, and without recourse to the return on capital, we should keep track of the imputed return on capital (based on our forecasts of operating income and capital invested) to ensure that it stays within reasonable bounds.

The Little Book of Valuation

Aswath Damodaran

****How to identify Growth Stocks? You should not try to identify a growth stock using financial ratios alone.

Wal-Mart has been a great growth stock, giving an 80,000 percent return over a 38-year period since 1970, when shares first became publicly available, or an incredible 35% per year.



How to identify Growth Stocks?

The success of a business, and hence its growth, depends primarily on its customers.  To find a great growth business, you need to evaluate it from a customer's point of view.  Once you are satisfied that the company's sales and earnings will continue to grow and that you can buy the stock at a reasonable price, buy and hold it for a long time.



Here is an important lesson:  How NOT to identify Growth Stocks?

Let's start with how NOT to identify a growth stock because it is especially important if you have been considering value investing.

You should not examine the financial fundamentals immediately after you have discovered a company that may grow in leaps and bounds for many years.  Do not emphasize the fundamentals much.

• In other words, when you start thinking about a growth stock, do not start thinking about the historical P/E ratio or, for that matter, any other quantitative measure that you might have learned in business school.  
• If you start thinking about traditional financial ratios, you will start thinking of value stocks, and you will probably never pick a great growth stock.  You would never have picked shares in Microsoft, Wal-Mart, or Home Depot if you had looked at the fundamentals soon after the companies went public.  
• Even if you knew these were incredible companies, you would have missed their tremendous potential.

We are not suggesting that traditional financial ratios are not important; we are simply suggesting that you should not try to identify a growth stock using financial ratios alone. 

The QVM approach to finding promising Growth Stocks

QUALITY:  I recommend that you start by examining earnings for several years because companies that have grown strongly for several years, on average, are sound candidates to generate good earnings in the future.

VALUE:  Before you buy a growth stock, you should consider the possibility that the price may already be reflecting a high growth potential.  Evaluate its P/E ratio or, preferably, compute its intrinsic value.

MANAGEMENT:  You will need to examine the qualitative variables, such as the quality of management and company culture, as they are the true underpinnings of future growth.

Overall, success in growth investing requires you to have 

• a very good knowledge of the company's business and 
• an ability to forecast its earnings well.

These most important determinants of your success in investing can be abbreviated as the QVM approach

Q = Quality - the quality of the company you own
V = Value - the price you paid for your stock
M = Management - the integrity of its management

Buffett on “Small, Unknown Companies”

http://docs.google.com/present/view?id=dfz95fm7_598g7gppkdf

Buffett at U of Kansas

http://www.valueplays.net/wp-content/uploads/vinvesting-com.pdf

University of Kansas : Warren Buffett Q&A

Notes by Professor Hirschey, University of Kansas ( May 6, 2005 )

Question: According to a business week report published in 1999, you were quoted as saying “it's a huge structural advantage not to have a lot of money.  I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I

was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much

money in today's environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies

that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy

up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in

cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn't have had to buy issue after issue of

different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into

the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50's. Money gets to be an anchor on performance. At Berkshire's

size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.

Q: Since Ben Graham isn't around anymore, what money managers do you respect today? Is there a Ben Graham today?

You don't need another Ben Graham. You don't need another Moses. There were only Ten Commandments; we're still waiting for the eleventh (j/k). His investing

philosophy is still alive and well. There are disciples of him around, but all we are doing is parroting. I did read Phil Fisher later on, which showed the more qualitative

aspects of businesses. Common stocks are part of a business. Markets are there to serve you, not to instruct you. You can often find a couple of companies that are

out of line. Find one; get rich. Most people think that what the stock does from day to day contains information, but it doesn't. It isn't just something that wiggles

around. The stock market is the best game in the world. You can take advantage of people who have no morals. High prices inside of a year will typically be 100% of

the low price. Businesses don't change in value that much. That is simply crazy. There are extreme degrees of fluctuation, and Mr. Market will call out the prices. Wait

until he is nutty in one direction or the other. Put in a margin of safety. Don't find a bridge that says no more than 10,000 pounds when you have a 9800 pound vehicle.

It isn't a function of IQ, but receptivity of the mind.

When investing you don't have to invest in all 10,000 companies available, you just have to find the one that is out of line. Mr. Market is your servant. Mr. Market is

your partner and wants to sell the business to you everyday. Some days he is very optimistic and wants a high price, others he is pessimistic and will sell at a low price.

You have to use this to your advantage. The market is the greatest game in the world. There is nothing else that can, at times, get this far out of line with reality. For

example, land usually only fluctuates within a 15% band. Negotiated transactions are less volatile. Some get this; others don't. Just keep your wits about you and you

can make a lot of money in the market.

Q: Do you expect the stock market premium to continue to be 6.5% over bonds?

I don't think that the stock market will return 6.5% over bonds in the future. Stocks usually yield a little more, but that isn't ordained. Every once in a while, stocks will

get very cheap, but it isn't ordained in scripture that this is so. Risk premiums are mostly nonsense. The world isn't calculating risk premiums.

Best book prior to Graham was written by Edgar Lawrence Smith in 1924 called Common Stocks as Long Term Investments. It was a study that evaluated how

bonds compared to stocks in various decades of the past. There weren't a whole lot of publicly traded companies back then. He thought he knew what he was going to

find. He thought that he'd find that bonds outperformed stocks during periods of deflation, and stocks outperformed during inflationary times. But what he found was

that stocks outperformed the bonds in nearly all cases. John M. Keynes then enumerated the reasons that this was so. He said that over time you have more capital

working for you, and thus dividends would grow higher. This was novel information back then and investors then went crazy and started buying stocks for these higher

returns. But then they started to get crazy, and no longer really applied the sound tactics that made the reasons given in the book true. Be careful that when you buy

something for a sound reason, make sure that the reason stays sound.

If you buy GM, you need to write the price and the respective market valuation. Then write down why you are buying the business. If you can't, then you have no

business doing it.

Quote from Ben Graham: “You can get in more trouble with a sound premise than an unsound premise because you'll just throw out the unsound premise”.

Q: What was your biggest mistake?

First off, follow Graham and you'll be fine.

My biggest mistakes were errors of omission vs. commission. Berkshire Hathaway was also a big mistake. Sometimes the opportunity costs of keeping money in

something (like a lousy textile business) can be a drag on Berkshire's performance. We didn't learn from the previous mistake and bought another textile mill

(Womback Mills) 6-7 years after buying Berkshire Hathaway. Meanwhile, I couldn't run the one in New Bedford.

Tom Murphy, my friend, bought the newspaper in Fort Worth. The previous ownership of these entities owned NBC as well, but he wanted to divest the NBC affiliate

- $30 million to buy, doing $75 million in earnings. It was really a pretty good company, but he wanted to sell it anyway. There wouldn't be many more of it. Network

television stations don't require excessive brains to run. They add a lot of money to our bottom lines.

We have never lost lots of money in things, except in insurance after 9/11. We don't do the kinds of things that lose you a lot of money. We just might not be finding the

“best” opportunities.

Don't worry about mistakes. You'll make mistakes. Get over it. At the same time, it's important to learn from someone else's mistakes. You don't want to make too

many mistakes.

Side note: Warren once asked Bill Gates, “If you could only hire from one place, where would it be?” Gate's reply was Indian Institute of Technology.

Q: Could you comment on your currency position?

We have about $21 billion in about 11 foreign currencies. We have $60-70 billion in things that are denominated in US Dollars. We still have a huge US bias. If

Martians came down with currency certificates and could choose any currency on earth, I doubt it would be 80% in US Dollars.

We are following policies that make me doubt that our currency will not follow a downward spin. We lost $307 million this quarter. The net gain since we started

holding foreign currencies in 2002 is $2.1 billion. We have to mark these future contracts to market daily. If we owned bonds instead of sterling forward contracts, it

wouldn't fluctuate around so much.

Identifying bubbles is fairly easy. You don't know how big they will get and you don't know when they will pop. You don't know when midnight will hit, but when it

does, it turns carriages to pumpkins and mice. What markets will do is pretty easy. When they will do it is more difficult. Some people want to stick around for the last

dance, and they thought that a bigger fool would be just around the corner tomorrow.

When we bought those junk bonds, I didn't know we would make $4 billion in such a short time. It would have been better if it wouldn't have happened so quickly, as

we would have gotten a bigger position.

Q: When did you know you were rich?

I really knew I was rich when I had $10,000. I knew along time ago that I was going to be doing something I loved doing with people that I loved doing it with. In

1958, I had my dad take me out of the will, as I knew I would be rich anyway. I let my two sisters have all the estate.

I bet we all in this room live about the same. We eat about the same and sleep about the same. We pretty much drive a car for 10 years. All this stuff doesn't make it

any different. I will watch the Super Bowl on a big screen television just like you. We are living the same life. I have two luxuries: I get to do what I want to do every

day and I get to travel a lot faster than you.

You should do the job you love whether or not you are getting paid for it. Do the job you love. Know that the money you will follow. I travel distances better than you

do. The plane is nicer. But that is about the only thing that I do a whole lot different.

I didn't know my salary when I went to work for Graham until I got his first paycheck. Do what you love and don't even think about the money. I will take a trip on

Paul Allen's Octopus ($400M yacht), but wouldn't want one for myself. A 60 man crew is needed. They could be stealing, sleeping with each other, etc. Professional

sports teams are a hassle, especially when you have as much money as him. Fans would complain that you aren't spending enough when the team loses.

If there is a place that is warm in the winter and cool in the summer, and you do what you love doing, you will do fine. You're rich if you are working around people

you like. You will make money if you are energetic and intelligent. This society lets smart people with drive earn a very good living. You will be no exception.

Q: What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lambert do at bringing Kmart and Sears together?

Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would

be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network

television station 50 years ago, you didn't really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

Retailing is like shooting at a moving target. In the past, people didn't like to go excessive distances from the street cars to buy things. People would flock to those

retailers that were near by. In 1996 we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn't going to be a winner, long-term,

in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a

great guy running it, and we still couldn't win. So we sold it around 1970. That store isn't there anymore. It isn't good enough that there were smart people running it.

It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears' management (500 people).

They've captured some savings already.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one

competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn't make any money.

How many retailers have really sunk, and then come back? Not many. I can't think of any. Don't bet against the best. Costco is working on a 10-11% gross margin

that is better than the Wal-Mart's and Sams'. In comparison, department stores have 35% gross margins. It's tough to compete against the best deal for customers.

Department stores will keep their old customers that have a habit of shopping there, but they won't pick up new ones. Wal-Mart is also a tough competitor because

others can't compete at their margins. It's very efficient.

If Eddie sees it as impossible, he won't watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won't be able to compete against

Costco's margins.

Q: What led you to develop your values and goals at an early age?

I was lucky because I knew what I loved at an early age. I was wired in a certain way when I was born, and I was lucky enough to stumble upon some books at a

library at a very early age. In 1930, I won the ovarian lottery. If I had been born 2000 years ago, I'd have been somebody's lunch. I couldn't run fast, etc.

I was lucky. I had a terrific set of parents. My father was an enormous inspiration for me. The job when you are a parent is to teach them. Be a natural hero. They are

learning from you every moment you are around. There is no rewind button. If your parents do what they say and their values match what they teach you, you are

lucky. What I observed in the world was consistent with what my parents taught me. That was important. If you are sarcastic, and use it as a teaching tool to kids,

they'll never learn to get over it. Those first few years they are very impressionable.

Q: Could you discuss your views on estate planning and how you will allocate your wealth to your children?

It really reflects my views on how a rich society should behave. If it weren't for this society, I wouldn't be rich. It wasn't all me. Imagine if you were one of a pair of

identical twins and a genie came along and allowed you to bid on where you could be born. The money that you bid is how much you had to agree to give back to

society, and the one who bids the most gets to be born in the US and the other in Bangladesh. You would bid a lot. It is a huge advantage to be born here.

There should be no divine right of the womb. My kids wouldn't go off and do nothing if I give them a lot of money, but if they did, that would be a tragedy. $30 billion

will be generated from estate taxes, which will go to help pay for the war in Iraq and other things. If you take away the estate tax, that money will have to come from

somewhere else. If not from estate taxes then you inherently get it from poorer citizens. Less than 2% of estates will pay the estate tax. They would still have $50 million

left over on average. I think those that get the lucky tickets should pay the most to the common causes of society. I believe in a big redistribution. Wealth is a bunch of

claim checks that I can turn in for houses, etc. To pass those claim checks down to the next generation is the wrong approach. But for those that think I am

perpetuating the welfare state, consider if you are born to a rich parent. You get a whole bunch of stocks right at the beginning of your life, and thus you are sort of on a

welfare state of support from your rich parents from the beginning. What's the difference?

At $100,000 a year, I can find 10 people to paint my portraits to find the perfect one. I have that kind of money. But that is a waste, as those people could be doing

something useful. I feel the same way about my kids and other heirs. They should be doing things that help to contribute to society.

Q: What kind of impact will the demographic shift (i.e. baby boomers) have on the United States?

We aren't big on demographic trends. It's difficult to translate that information into profitable decisions. It is hard to figure out what businesses will prosper in the future,

based on macro trends. See's candy is for anyone and Fruit of the Loom is for people who need underwear today. We want to be right on something that will work

right now, not something that might work in the future. I doubt that Wal-Mart spends a lot of time on demographics. They instead focus on where to put the store and

what to put on the shelves. I've never found those kinds of stats useful. People were all excited to go into stocks 6 years ago, but it wasn't because of demographic

trends.

Warren then referred to a recent WSJ article written by Jeremy Siegel that discussed funds flowing out of investments because baby boomers will need to cash in their

investments during retirement. He said he respected Siegel, but he doesn't find fund flows data useful.

Q: What would Berkshire be like if you hadn't met Charlie Munger?

It would be very different, but I could say the same thing about a lot of other people, too. I've had a lot (at least a dozen) of heroes, including my parents. Charlie and I

didn't meet until 1959, although he grew up a half a block from where I lived. Charlie was 35 and I was 29. We've been partners ever since. He is very strong-minded,

but we've never had an argument that whole time. I've never been let down once. It must be a terrible feeling to be let down by a hero.

Hang around people who are better than you all the time. You do pick up the behavior of people who are around you. It will make you a better person. Marry upward.

That is the person who is going to have the biggest effect on you. A relationship like that over the decades will do nothing but good.

Q: Are investors more or less knowledgeable today compared to ten years ago?

There is no doubt that there are far more “investment professionals” and way more IQ in the field, as it didn't use to look that promising. Investment data are available

more conveniently and faster today. But the behavior of investors will not be more intelligent than in the past, despite all this. How people react will not change – their

psychological makeup stays constant. You need to divorce your mind from the crowd. The herd mentality causes all these IQ's to become paralyzed. I don't think

investors are now acting more intelligently, despite the intelligence. Smart doesn't always equal rational. To be a successful investor you must divorce yourself from the

fears and greed of the people around you, although it is almost impossible.

Do you think Ponzi was crazy? The tech and telecom madness that existed just 6 years ago is right up there with the craziest mania's that have ever happened. Huge

training in capital management didn't help.

Take Long Term Capital Management. They had 100's of millions of their own money, and had all of that experience. The list included Nobel Prize winners. They

probably had the highest IQ of any 100 people working together in the country, yet the place still blew up. It went to zero in a matter of days. How can people who are

rich and no longer need more money do such foolish things?

Q: What effect does large institutional ownership have on stock price volatility?

Never has so much been managed by so few that care so much about what happens tomorrow. So much of the world of investing is people who are trying to beat

indexes, and they have a willingness and eagerness to make decisions in the next 24 hours. This condition didn't exist years ago. It has created a “hair trigger” effect. An

example of this hair trigger effect was Black Monday in '87. The cause was program trading and stop loss orders.

Q: What sectors are hurting? Is there a bear market coming?

Humans are still made up of the same psychological makeup, and opportunities will always present themselves. All these people have not gotten more rational. They are

moved by fear and greed. But I'm never afraid of what I am doing. What are directors thinking [by not repurchasing shares] if the business is selling on a per share basis

for one-fourth of what the whole business would sell for? They don't always think rational. I simply don't have that problem.

Berkshire owned the Washington Post, the ABC network and Newsweek. It was selling for $100 million based on the stock price. No debt. You could have held an

auction, and sold off the companies individually for $500M total, but $100M was the price. In other words they were willing to sell us money that was worth $1 for

$0.25. According to efficient markets, the beta was higher when the stock was at $20 than at $37. This is insanity. We bought what was then worth $9 million that is

now worth $1.7 billion.

Q: How do you feel about divisions of conglomerates trying to horde capital?

Berkshire wants the capital in the most logical place. Berkshire is a tax efficient way to move money from business to business, and we can redeploy capital in places

that need them. Most of the managers of companies we own are already independently rich. They want to work, but don't have to. They don't horde capital they don't

need.

Q: How do you feel about the current real estate environment?

If you are buying to own a home, that is fine. Otherwise, it seems to be getting into bubble territory. We're not excited about real estate because generally there is not

enough return at current prices.

Mistakes to Avoid - Swinging for the Fences

Swinging for the Fences

Loading up your portfolio with risky, all-or-nothing stocks, is a sure route to investment disaster. In other words, swing for the fences on every pitch.

For one thing, the insidious math of investing means that making up large losses is a very difficult proposition - a stock that drops 50% needs to double just to break even.

For another, finding the next Microsoft when it's still a tiny start-up is really, really difficult. You're much more likely to wind up with a company that fizzles than a truly world-changing company, because it's extremely difficult to discern which is which when the firm is just starting out.

In fact, small growth stocks are the worst-returning equity category over the long haul. Why?

First, the numbers: According to Professor Kenneth French at Dartmouth, small growth stocks have posted an average annual return of 9.3% since 1927, which is a good deal lower than the 10.7% return of the S&P 500 over the same time period. The 1.4% difference between the two returns, has an absolutely enormous effect on long-run asset returns - over 30 years, a 9.3% return on $1,000 would yield about $14,000, but a 10.7% return would yield more than $21,000.

Moreover, many smaller firms never do anything but muddle along as small firms - assuming they don't go belly up, which many do. For example, between 1997 and 2002, 8% of the firms on the Nasdaq were delisted each year. That's about 2,200 firms whose shareholders likely suffered huge losses before the stocks were kicked off the Nasdaq.

Also read:
Compounded Effects of Market Underperformance