Learn How to Invest like Warren Buffett

http://www.buffettsbooks.com/index.html

http://www.youtube.com/user/BuffettsBooks/videos (38 videos)

Course 1

Introductory Lessons to Value Investing

Course 1 Lesson Plan

Course 2

Intermediate Lessons to become an Intelligent Investor

Course 2 Lesson Plan

Course 3

Advanced Lessons to Security Analysis

Course 3 Lesson Plan

How Warren Buffett hedges himself against Inflation

17 minutes into the video: Warren Buffett talks about investing and inflation.
Good businesses are the cheapest investment to acquire by far.
Buffett: "I love owning businesses."

Calculating a College Degree's True Value

How much is a college diploma actually worth? The perennial question asked by every former English, philosophy, and art history major now has an answer in some states. For University of Virginia students, it pays to major in engineering—$60,300, on average, 18 months after graduation—rather than sociology ($33,154), or worse, biology ($27,209). In Tennessee, a graduate of Dyersburg State Community College with an associate’s degree in health earns an average $5,000 more than someone who majored in health and picked up a bachelor’s at the University of Tennessee at Knoxville, the state’s flagship school.

With tuition and student debt skyrocketing and dim job prospects awaiting many graduates, states are trying to show residents what kind of return they can realistically expect for investing in a degree from a public college or university. That’s why Virginia, Tennessee, and Arkansas are collecting salary data on their graduates and posting it online at CollegeMeasures.org, a website run by a former education official in the Bush administration. The database, which doesn’t reveal any names or other identifying information, shows students how much money they can expect to earn based on the major and school they choose. Colorado, Nevada, and Texas will also begin using it in early 2013.

“What we want is for students to make informed decisions,” says Tod Massa, director of policy research and data warehousing at Virginia’s State Council of Higher Education. Massa, who’d been pushing for such a database for years, had little success until 2011, when the Virginia legislature passed a law mandating that the state publish salary data for graduates of all colleges and universities, public and private. Schools “need to coordinate their level of student borrowing with [students’] likely ability to repay,” Massa says. Virginia shares its information with CollegeMeasures and operates its own website, publishing data for graduates up to five years out of school.

http://www.businessweek.com/articles/2012-12-20/calculating-a-college-degrees-true-value#r=nav-r-story

Chinese Stocks Lose Their Luster

The average price-earnings ratio of Chinese stocks sank 76 percent over the past decade as growth cooled and investors soured on the lumbering state-owned enterprises that dominate the country’s main equity index.

In a World Full of Risk, Why Are Investors So Calm?

Leuthold’s monthly Risk Aversion Index, which bakes together various credit and swap spreads, commodity and currency prices, and relative asset returns to offer a broad gauge of skittishness, is at a record low going back to 1980. That span includes the Crash of ’87, the rolling emerging-market contagions of the 1990s, and the multiple human and financial calamities of the past decade.

How does this overwhelming calm jibe with the prevailing uncertainty of our times?

“The so-called Bernanke put—or, more accurately, global central bank put—is suppressing most of the risk and fear gauges,” says Leuthold’s Chun Wang. “And just about all asset classes, risky or risk-free, have been bid up.” Wang finds that low-fear backdrops like this historically last much longer than high-fear ones, and that increasing signs that housing and China are on the mend only add to the general chill-out.

It’s been a paradoxical climate for investors, who have seen the rather unique confluence of low economic growth with double-digit global equity returns—something that normally doesn’t happen in the absence of post-recession relief rallies and/or significant interest-rate declines.

Some are already conflating all this calm with complacency, warning that danger lies ahead.

http://www.businessweek.com/articles/2012-12-19/in-a-world-full-of-risk-why-are-investors-so-calm#r=rss

How to select the better company to invest in? Comparing Companies.

If the companies you wish to compare are in different industries, you should use the industry as another subjective criterion.  You can compare investments in different industries if you're interested in the best investment opportunity.  Some criteria; e.g., profit margins, differ from industry to industry so you will want to overlook those items.  You may find one industry to be more appealing to you than another and should allow that criterion to help with your decision.

The criteria you should use for comparison are not limited to the "value" and "quality" criteria.  The most important criteria are those that address "quality."  Beyond that, the price-sensitive "value" criteria will address the potential rewards and risk.  However, such items as the industry or company size may have a bearing on your decision as well, although they are less critical than some of the others.

For comparison, you should select no more than 5 companies.  More than five companies becomes a "screening" exercise and becomes unwieldy.  While companies may be in a variety of industries, some comparison criteria such as profit margins may be valid only when comparing companies in the same industry.

You should circle a value if it's better than most of the others.  Circle the values that are better than most for each criterion.  It may be more than one - or all - if they are close enough not to be obviously ruled out.  All you can hope to accomplish by circling the criteria is to sharpen your judgement and separate the chaff from the wheat.

Pick a winner on the basis of your overall subjective assessment.  Base your decision on your overall subjective assessment, using the number of circles as a guide and the more subjective items such as the industry the company is in, the size of the company, etc. as tie breakers.  The number of circles is important only as a starting place and guide; and should be tempered with your assessment and "gut feeling" about the company when the numbers are close.  

Good quality company but trading at high price - Add this to your "watch list."

If the price is too high, you should add the company to your "watch list."  You have found the company to be a good quality company but the price is too high.  If it's much too high, put it on your "watch list" and wait for it to come down.

In rare circumstances, you may wish to put in a market order; but you will not want to do this in every case.

The "buy price" is the price at which both your risk and reward criteria are met.  This is the highest price you can pay and realize both a Total Return that will double your money every five years and where the risk of loss is less than one third of the potential gain.

The reward should be at least three times the risk.  Even though you may sometimes accept a total return of less than 15% because of the contribution that the stock can make to your portfolio's stability, you don't want to accept a Risk index of much above 25%.

If the Risk index is zero or negative, you should question your assumptions about the quality issues.  You will want to question why the price of the stock is so low.  What do others know about the company that you don't know?  If you're a new investor, you should move on to another candidate.  If you can satisfy yourself that the price is depressed for no good reason, then you can be a contrarian and buy the stock.


Additional note:

Definition of 'Market Order'

An order that an investor makes through a broker or brokerage service to buy or sell an investment immediately at the best available current price. A market order is the default option and is likely to be executed because it does not contain restrictions on the buy/sell price or the timeframe in which the order can be executed.

A market order is also sometimes referred to as an "unrestricted order."

Investopedia explains 'Market Order'

A market order guarantees execution, and it often has low commissions due to the minimal work brokers need to do. Be wary of using market orders on stocks with a low average daily volume: in such market conditions the ask price can be a lot higher than the current market price (resulting in a large spread). In other words, you may end up paying a whole lot more than you originally anticipated! It is much safer to use a market order on high-volume stocks.

Read more: http://www.investopedia.com/terms/m/marketorder.asp#ixzz2FjYO8xoI



Calculating the Risk Index

Risk Index
= (Current Price - Potential Low Price) / (Potential High Price - Potential Low Price)

The result is the risk index, the percentage of the deal that is risk.
We look for a risk index of 25 percent or less, meaning that only a quarter of the proposition or less is risk.
We would then have at least 75 percent to gain versus at most 25 percent to lose; so the reward is at least three times the risk.

Be conservative in your estimates for future growth.

Never estimate future earnings growth:

• to exceed the growth of sales
• to exceed 20 percent
• to exceed its historical growth rate
• to exceed the analysts' estimates.

Be conservative in your estimates for future growth.  It's always better to underestimate than to overestimate.

Beware that the worse a company performs, the better value its stock will appear to be.

The worse a company performs, the better value its stock will appear to be.

Because declining fundamentals will prompt a company's shareholders to sell, the price will decline.  This will cause all the value indicators to show that the price has become a bargain.  It's not.

Confine your study to companies with good sales or earnings growth.

Don't bother to continue with a stock study if sales or earnings growth is inadequate.

Sales growth is inadequate if it is below the guidelines for the size of the company you are studying (ranging from around 7 percent for a large company to 12 percent for a smaller one).

Earnings growth should be around 15 percent or better; but you can accept slower growth from companies whose dividends contribute substantially to the total return.

Why you shouldn't invest in companies whose business you don't understand?

You shouldn't invest in companies whose business you don't understand because you won't be able to judge their future potential and vulnerabilities.

While intimacy with a company's business is not essential to making a decision to buy the stock, later "hold" or "sell" decisions may be clearer if you understand its competitive position in the marketplace, the value of its products or services, and the character of its industry's problems.  These are common-sense issues for which a simple understanding of the business will suffice.

Warren Buffett on how to obtain superior profits from stocks.

     An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style.  He can earn them only by carefully evaluating facts and continuously exercising discipline. 

     Common stocks are the most fun.  When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs.  

• We often find no equities that come close to meeting our tests.  
• We do not predict markets, we think of the business.  
• We have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future.

Warren Buffett's Investment Objectives

Goals

     Our long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis.  We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.  We are certain that the rate of per-share progress will diminish in the future - a greatly enlarged capital base will see to that. We will be disappointed if our rate does not exceed that of the average large American corporation.

2.     Charlie Munger and I can attain our long-standing goal of increasing Berkshire's per-share intrinsic value at an average annual rate of 15%.  We have not retreated from this goal.  We again emphasize that the growth in our capital base makes 15% an ever-more difficult target to hit.

3.     What we have going for us is a growing collection of good-sized operating businesses that possess economic characteristics ranging from good to terrific, run by managers whose performance ranges from terrific to terrific.  You need have no worries about this group.

4.     The capital-allocation work that Charlie and I do at the parent company, using the funds that our managers deliver to us, has a less certain outcome: It is not easy to find new businesses and managers comparable to those we have.

Comments:

1.  Maximise growth in net worth over the long term.

2.  Aiming for average annual growth rate of 15%.

3.  Collect a group of great companies run by great managers.

4.  Re-allocate the funds generated by these great companies.

Warren Buffett on Arbitrage

Arbitrage

     Berkshire’s arbitrage activities differ from those of many arbitrageurs.  First, we participate in only a few, and usually very large, transactions each year.  Most practitioners buy into a great many deals perhaps 50 or more per year.  With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks.  This is not how Charlie nor I wish to spend our lives.  Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation.  So far, Berkshire has not had a really bad experience.  But we will - and when it happens, we’ll report the gory details to you.

     The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced.  We do not trade on rumors or try to guess takeover candidates.  We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.

     Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound.  In 1954, a temporary shortage of cocoa caused the price to soar to over 60 cents.  Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

     The 1954 Tax Code came to the rescue.  It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business.  Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity.  Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.

     For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.  The profits were good and my only expense was subway tokens.

     The architect of Rockwood’s restructuring was an unknown brilliant Chicagoan, Jay Pritzker, then 32.  If you’re familiar with Jay’s subsequent record, you won’t be surprised to hear the action worked out rather well for Rockwood’s continuing shareholders also.  From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses.  In recent years, most arbitrage operations have involved takeovers, friendly and unfriendly.  With acquisition fever rampant and anti-trust challenges almost non-existent, and with bids often ratcheting upward, arbitrageurs have prospered mightily.  In Wall Street the old proverb has been reworded: “Give a man a fish and you feed him for a day.  Teach him how to arbitrage and you feed him forever.”

     To evaluate arbitrage situations you must answer four questions: 

(1) How likely is it that the promised event will indeed occur?  

(2) How long will your money be tied up?  

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?  and 

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

     Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business.  On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm.  Arcata was in the printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to expand Redwood National Park.  The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate.  The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it.  The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.  Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem.  To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.

     Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.”  A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.  However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.  We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management were clearly determined to sell.  If KKR went away, Arcata would likely find another buyer, though the price might be lower.

     Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.  We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company.  The initial announcement said that the $37.00 would be paid in January, 1982.  Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% - not counting the redwood claim, which would have been frosting.

     All did not go perfectly.  In December it was announced that the closing would be delayed a bit.  Nevertheless, a definitive agreement was signed on January 4.  Encouraged, we raised our stake, buying at around $38.00 per share and increasing our holdings to 655,000 shares, or over 7% of the company.  Our willingness to pay up - even though the closing had been postponed - reflected our leaning toward “a whole lot” rather than “zero” for the redwoods.

     Then, on February 25 the lenders said they were taking a “second look” at financing terms “ in view of the severely depressed housing industry and its impact on Arcata’s outlook.”  The stockholders’ meeting was postponed again, to April.  An Arcata spokesman said he “did not think the fate of the acquisition itself was imperiled.”  When arbitrageurs hear such reassurances, their minds flash to the old saying: “He lied like a finance minister on the eve of devaluation.”

     On March 12 KKR said its earlier deal wouldn’t work, first cutting its offer to $33.50, then two days later raising it to $35.00.  On March 15, however, the directors turned this bid down and accepted another group’s offer of $37.50 plus one-half of any redwood recovery.  The shareholders okayed the deal, and the $37.50 was paid on June 4.  We received $24.6 million versus our cost of $22.9 million; our average holding period was close to six months.  Considering the trouble this transaction encountered, our 15% annual rate of return excluding any value for the redwood claim - was more than satisfactory.  But the best was yet to come.  The trial judge appointed two commissions, one to look at the timber’s value, the other to consider the interest rate questions.  In January 1987, the first commission said the redwoods were worth $275.7 million and the second commission recommended a compounded, blended rate of return working out to about 14%.

     In August 1987 the judge upheld these conclusions, which meant a net amount of about $600 million would be due Arcata.  The government then appealed.  In 1988, though, before this appeal was heard, the claim was settled for $519 million.  Consequently, we received an additional $29.48 per share, or about $19.3 million, and another $800,000 in 1989.   

      At year end 1988, our only major arbitrage position was 3,342,000 shares of RJR Nabisco with a cost of $281.8 million and a market value of $304.5 million.  In January we increased our holdings to roughly four million shares and in February we eliminated our position.  About three million shares were accepted when we tendered our holdings to KKR, which acquired RJR, and the returned shares were promptly sold in the market.  Our pre-tax profit was a better-than-expected $64 million.

     Earlier, another familiar face turned up in the RJR bidding contest: Jay Pritzker, who was part of a First Boston group that made a tax-oriented offer.  To quote Yogi Berra; “It was deja vu all over again.” During most of the time when we normally would have been purchasers of RJR, our activities in the stock were restricted because of Salomon’s participation in a bidding group.  Customarily, Charlie and I, though we are directors of Salomon, are walled off from information about its merger and acquisition work.  We have asked that it be that way: The information would do us no good and could, in fact, occasionally inhibit Berkshire’s arbitrage operations.

     However, the unusually large commitment that Salomon proposed to make in the RJR deal required that all directors be fully informed and involved.  Therefore, Berkshire’s purchases of RJR were made at only two times: first, in the few days immediately following management’s announcement of buyout plans, before Salomon became involved; and considerably later, after the RJR board made its decision in favor of KKR.  Because we could not buy at other times, our directorships cost Berkshire significant money.

     Considering Berkshire’s good results in 1988, you might expect us to pile into arbitrage during 1989.  Instead, we expect to be on the sidelines.

     We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them.  We know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.  We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. 

10 Amazing Investment Quotes You've Probably Never Heard

By Morgan Housel
December 13, 2012

There are an uncountable number of articles promising "the best investment quotes of all time," or some variation. Most are good reads; but they've become predictable. You know exactly what they're going to contain: Buffett's line about being fearful when others are greedy, Peter Lynch's deal about buying what you know, and a few classic Ben Graham hits. Same quotes again and again.

So, a while back, I did some digging and found 10 great investing quotes that aren't as popular. Enjoy. 

"Risk is what's left over when you think you've thought of everything." -- Carl Richards

Financial advisors say you should have six months of expenses saved as an emergency fund. That's planning. The average duration of unemployment today is 10 months. That's risk.

"In investing, what is comfortable is rarely profitable." -- Robert Arnott

Think about this: Three years after the book Dow 36,000 was published, stocks were down 40%. Three years after The Great Depression Ahead  was published, stocks had doubled.

"When a possibility is unfamiliar to us, we do not even think about it." -- Nate Silver

The two biggest financial stories of the last 12 years were 9/11, and the financial crisis. Be honest with yourself: How often did you think about the possibility of these two things happening before they actually happened? If you're like 99.9% of people, the answer is never.

"People focus on role models; it is more effective to find antimodels -- people you don't want to resemble when you grow up." -- Nassim Taleb

You want to study the greats -- great investors like Buffett and Lynch, and great companies like Apple (NASDAQ: AAPL  ) and Costco (NASDAQ: COST  ) . But you also want to study the failures. Kodak. General Motors (NYSE: GM  ) . Enron. Long-term Capital Management. Lehman Brothers. You'll probably learn more from the failures than you will from the greats.

"Pundits forecast not because they know, but because they are asked." -- John Kenneth Galbraith

There's zero accountability of financial pundits. In fact, the most popular media faces are almost never right, as websites like PunditTracker.com are showing. Keep that in mind when sifting through financial news.

"Being slow and steady means that you're willing to exchange the opportunity of making a killing for the assurance of never getting killed." -- Carl Richards

I recently interviewed value investor Mohnish Pabrai, who had dinner a few years ago with Buffett. Pabrai asked Buffett what happened to a former business partner he used to pick stocks with. (I don't want to name him because he's still in business today.) Buffett said they went their separate ways because the former partner was too eager to get rich, which meant leverage and, eventually, margin calls. Meanwhile, Buffett and partner Charlie Munger "always knew they were going to be rich and were in no hurry." Look who came out ahead.

"If you look carefully, almost all Old Money secrets can be traced to a single source: a longer-term outlook." -- Bill Bonner

It's well known that markets have become more short term. So what? No one said you have to become short term. My colleague Jeremy Phillips calls this "time arbitrage," or "the concept of buying a stock from those with a different time horizon, and selling on our own terms."

"No one can foresee the consequences of trivia and accident, and for that reason alone, the future will forever be filled with surprises." -- Dan Gardner

Speaks for itself. Some of the best investors have succeeded not because they've predicted the future, but because they've dealt with surprises better than most. That usually means having more cash and less debt than seems reasonable.

"The stock market is a giant distraction to the business of investing." -- John Bogle

Motley Fool advisor Ron Gross says we should think of the market as a company market, not a stock market. Here's a good example: On May 10, 2010, the Dow Jones (DJINDICES:^DJI  )  briefly fell almost 1,000 points, as high-frequency traders tripped over themselves. But it's safe to say that not a single non-financial business in the world was affected in any measureable way. That's the difference between a company market and a stock market. 

"In the corporate world, if you have analysts, due diligence, and no horse sense, you've just described hell." -- Charlie Munger

Really smart people with Ph.D.s used sophisticated math models to conclude that mortgage lending was sound in 2005. They failed miserably. Country bumpkins who didn't know what a balance sheet was said, "Hey, my brother is broke and just got a $500,000 mortgage. That ain't right." They won. 

http://www.fool.com/investing/general/2012/12/13/10-amazing-investment-quotes-youve-probably-never.aspx?source=ihpdspmra0000001&lidx=3

Warren Buffett: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur.  The timing of these epidemics will be unpredictable.  And the market aberrations produced by them will be equally unpredictable, both as to duration and degree.  Therefore, we never try to anticipate the arrival or departure of either disease.  Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

As this is written, little fear is visible in Wall Street.  Instead, euphoria prevails - and why not?  What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. However, stocks can’t outperform businesses indefinitely.

Buffett allocates funds in ways that build per share intrinsic value.

At Berkshire, our managers will continue to earn extraordinary returns from what appear to be ordinary businesses.  As a first step, these managers will look for ways to deploy their earnings advantageously in their businesses.  What's left, they send to Charlie and me.  We then try to use those funds in ways that build per-share intrinsic value.  Our goal is to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.

Warren Buffett: Intrinsic Value and Capital Allocation

Intrinsic Value and Capital Allocation

     Understanding intrinsic value is as important for managers as it is for investors.  When managers are making capital allocation decisions - including decisions to repurchase shares - it's vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it.  This principle may seem obvious but we constantly see it violated.  And, when misallocations occur, shareholders are hurt.     

     For example, in contemplating business mergers and acquisitions, many managers tend to focus on whether the transaction is immediately dilutive or anti-dilutive to earnings per share (or, at financial institutions, to per-share book value).  An emphasis of this sort carries great dangers.  Going back to our college-education example, imagine that a 25-year-old first-year MBA student is considering merging his future economic interests with those of a 25-year-old day laborer.  The MBA student, a non-earner, would find that a "share-for-share" merger of his equity interest in himself with that of the day laborer would enhance his near-term earnings (in a big way!).  But what could be sillier for the student than a deal of this kind?

     In corporate transactions, it's equally silly for the would- be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure.  At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value.  Our approach, rather, has been to follow Wayne Gretzky's advice:  "Go to where the puck is going to be, not to where it is."  As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism.

     The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer's management; and they are a honey pot for the investment bankers and other professionals on both sides.  They usually reduce the wealth of the acquirer's shareholders, often to a substantial extent.  That happens because the acquirer typically gives up more intrinsic value than it receives.  Do that enough, says John Medlin, the retired head of Wachovia Corp., and "you are running a chain letter in reverse."    Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value.  Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally.  The company could distribute the money to shareholders by way of dividends or share repurchases.  Often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense.  That's like asking your interior decorator whether you need a $50,000 rug.

Warren Buffett: Book Value and Intrinsic Value

Book Value and Intrinsic Value

     We regularly report our per-share book value, an easily calculable number, though one of limited use.  Just as regularly, we tell you that what counts is intrinsic value, a number that is impossible to pinpoint but essential to estimate.

     For example, in 1964, we could state with certitude that Berkshire's per-share book value was $19.46.  However, that figure considerably overstated the stock's intrinsic value since all of the company's resources were tied up in a sub-profitable textile business.  Our textile assets had neither going-concern nor liquidation values equal to their carrying values.  In 1964, then, anyone inquiring into the soundness of Berkshire's balance sheet might well have deserved the answer once offered up by a Hollywood mogul of dubious reputation:  "Don't worry, the liabilities are solid."

     Today, Berkshire's situation has reversed: Many of the businesses we control are worth far more than their carrying value.  (Those we don't control, such as Coca-Cola or Gillette, are carried at current market values.)  We continue to give you book value figures, however, because they serve as a rough,  understated, tracking measure for Berkshire's intrinsic value. 

     We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.  Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move.  Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

     To see how historical input (book value) and future output (intrinsic value) can diverge, let's look at another form of investment, a college education.  Think of the education's cost as its "book value."  If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job.

     For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value.  First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education.  That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day.  The dollar result equals the intrinsic economic value of the education.

      Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth.  In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed.  In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.

     Now let's get look at Scott Fetzer, an example from Berkshire's own experience.  This account will not only illustrate how the relationship of book value and intrinsic value can change but also will provide an accounting lesson.  Naturally, I've chosen here to talk about an acquisition that has turned out to  be a huge winner.

    The reasons for Ralph's success are not complicated.  Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.  In later life, I have been surprised to find that this statement holds true in business management as well.  What a  manager must do is handle the basics well and not get diverted.  That's precisely Ralph's formula.  He establishes the right goals and never forgets what he set out to do.  On the personal side, Ralph is a joy to work with.  He's forthright about problems and is self-confident without being self-important.   He is also experienced.  Though I don't know Ralph's age, I do know that, like many of our managers, he is over 65.  At Berkshire, we look to performance, not to the calendar.  Charlie and I now keep George Foreman's picture on our desks.  You can make book that our scorn for a mandatory retirement age will grow stronger every year.

Warren Buffett: "Avoid these bargains."

Bargain Price

In the final chapter of The Intelligent Investor, Ben Graham wrote:  "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Many years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses.

    

In the summer of 1979, when equities looked cheap to me, I wrote a Forbes article entitled "You pay a very high price in the stock market for a cheery consensus." At that time skepticism and disappointment prevailed, and my point was that investors should be glad of the fact, since pessimism drives down prices to truly attractive levels. Now, however, we have a very cheery consensus. That does not necessarily mean this is the wrong time to buy stocks: Corporate America is now earning far more money than it was just a few years ago, and in the presence of lower interest rates, every dollar of earnings becomes more valuable. Today's price levels, though, have materially eroded the "margin of safety" that Ben Graham identified as the cornerstone of intelligent investing.

     My first mistake was in buying control of Berkshire. Though I knew its business - textile manufacturing - to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965, I was becoming aware that the strategy was not ideal.

     If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.  Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all.

     I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture:  It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. Now, when buying companies or common stocks, we look for first-class businesses, with enduring competitive advantages, accompanied by first-class managements.

     In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.

The investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.  Therefore, remember that time is the friend of the wonderful business, and the enemy of the mediocre.

Market value, business value, Short-term & Long-term Market Returns and the effects of GDP Growth

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

• GDP growth of 3 to 5%
• Productivity growth of 1 to 2%
• Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year? 

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually. 

But for a particular stock? 

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever? 

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen. 


GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total book selling business in the previous decade.



Main point:  
Business value and market value of a company grow further through increases in productivity (better profit margins) and through growing its market share (higher revenues).