Warren Buffett's textbook on investing . and life
November 5, 2008
PORTFOLIO POINT: The Snowball, a biography of Warren Buffett, is a very readable account of his philosophies and contains lessons for all investors.
Warren Buffett is the world's greatest living investor. No contest. But who is the "Sage of Omaha"? And how does he actually operate?
Until recently there have been a string of books about the man behind the Berkshire Hathaway group that offered limited insights, but never really captured the whole story because Buffett always refused to cooperate. Now all that has changed with the publication of The Snowball. Warren Buffett and the business of life, a comprehensive new official biography written by Alice Schroeder with the subject's full cooperation.
The book is an imposing 850 pages of text, with a further 150 pages of references. However, I found it easy to read, combining stories of Buffett's life experience and investing philosophy.
Most Eureka Report subscribers may be familiar with the basic aspects of Buffettology: the search for value in listed stocks; the resistance to market :noise"; the perspective of regarding stocks not as tradeable slices of equity but "parts of companies"; the long-term view.
As the book begins to widen our understanding of Buffett, Berkshire Hathaway is again in the news; not everyone believes Buffett's latest moves in taking positions at Goldman Sachs and General Electric will be successful. (Mark Carnegie writes on the debate around Buffett's motives in today's edition. See In defence of the king).
To my mind, the official biography adds significantly to our understanding of this singular investor, and in doing so it adds to our ability to copy his best ideas. In the end, I believe there are five key factors emerging in the burgeoning discipline that's becoming known as Buffettology:
An exceptionally intelligent investor
Several Buffett quotes deal with the issue of intelligence and investing, the tone of the quotes being that you don't have to be of great intelligence to be a great investor. For example this quote from Buffett: "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ . What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework."
These words seem to make investing a very egalitarian process, and there are signs that this is true. The oft-quoted example of this is the Mensa (people with high IQs) investment club which, over a 15-year period managed a return of just 2.5% a year when the investment index returned 15.2%.
However the new biography makes it clear that Buffett is an exceptionally intelligent person. He graduated very high up in his high school year (16 out of 350), despite not seeming to be overly engaged in these studies.
Prior to his first lesson in the Finance class at the Ivy League Columbia University, he had memorised the textbook Security Analysis, by Ben Graham and David Dodd, regarded as among the greatest investment minds of all time. The Graham-Dodd price/earnings multiple is still used as an alternative metric by market analysts (see today's feature by Gerard Minack, see Revaluing value).
Attending Dodd's lectures at Columbia, Buffett stood out from his class of undergraduates in exceptional fashion. Even though Dodd had co-authored the book, Buffett said that on the first day of class, "The truth is that I knew the book even better than Dodd. I could quote any part of it . I knew every example."
The margin of safety - in different times
The Snowball describes the idea of the margin of safety in the following way: "Investing is built on estimates and uncertainties. A wide margin of safety ensures that the efforts of good decisions are not wiped out by error." This concept was simply a margin of safety - assuming that if your estimate of the value of a share was $20, then buying it at $15 provides a buffer if you have made an error in your estimates of value.
In the early days of Buffett's investment, the margin of safety was very different from what it is today. Consider these examples from the book, from Buffett's early years of investing:
- Northern Pipeline, trading at $65, which had owned railway bonds valued at $95 per share - and which ended up distributing $110 of cash and shares to shareholders.
- National American, trading at $30 per share with annual earnings of $29 a share. (A P/E ratio of 1).
We don't see these sorts of examples of margin of safety in today's sharemarket. The opportunity to buy shares of operating companies at prices below the value of their cash or liquid assets, or companies trading on a P/E ratio of 1) simply does not exist.
In Buffett's early investment experiences, the margin of safety was making sure that what a company could still pay to the investor even if it was liquidated. If this value was greater than the share price, it provided a strong margin of safety.
The more recent application of the margin of safety by Buffett is less purist; that is, it brings in qualitative criteria alongside quantitative criteria. It has included looking at the "economic moat" around a business that makes it difficult to duplicate - such as the Coca-Cola brand - and great management, while still keeping an eye on the fundamentals of earnings and the return on the investors equity.
A dedicated entrepreneur
Buffett was interested in becoming wealthy from an early age, and engaged a number of money making ventures. They included:
Selling chewing gum and Coke around the neighbourhood from the age of six.
Selling peanuts and popcorn at football games from the age of 10.
Delivering papers (during which time he counted the bicycle and watch as work-related deductions for his income tax).
Collecting and re-selling golf balls.
A pin ball business (putting pin-ball machines in barber shops).
During this time he was also investing in stocks. It showed that from an early age he had a focus on money, and the express desire to become a millionaire. What's more, he had a willingness to engage with capitalism - both in terms of earning money from his own direct activities as well as investing.
Debt seems to be a dirty word to Buffett. The book highlights an interesting decision when he was a young man and looking to increase his investment exposure. He had existing capital of $19,738 and took a loan to borrow a further $5000.
In today's margin lending, that would be a loan to value ratio of 20% - excruciatingly conservative. (Today, 50% is often touted as a conservative loan to value ratio). Even in such a conservative situation, he still acknowledges his aversion to borrowing money. Nevertheless, he remains active in the derivatives market; there is a contradiction here, though not one the book fully explores.
The snowball effect
The snowball analogy is not often mentioned in the book (being that a snowball grows as it rolls down a hill), yet is central to its theme. Buffett acknowledges his interest in the miracle of compound interest early in life - and this drives a lot of his investment theory, building streams of cash that can be reinvested over time to build even bigger streams of cash.
The snowball effect in investments is only part of the story. Buffett also refers to the snowball effect as being related to "understanding the world and what kind of friends you accumulate" as well as being the "kind of person that snow wants to attach itself to".
The book focuses on this part of Buffett's life as well: how he made himself the kind of person that "snow" would attach to, and the way he accumulated powerful friends such as Washington Post publisher Katherine Graham, one time Coca-Cola chief executive Don Keogh and, ultimately, Microsoft's Bill Gates.
In talking recently with college students, he commented that:
"I packed my little snowball very early, and if I had packed it 10 years later it would have been different than where it stands on this hill right now. So I recommend to students that if you start out a little ahead of the game - it doesn't have to be a lot, but it's so much better than starting out behind the game. And credit cards really get you behind the game."
Like many people with an interest in the process of investing, I have been an observer of Buffett and his wisdom for most of my working life. Every year I look forward to his annual Berkshire Hathaway letter to shareholders. This book provides a substantial perspective to my observations of Buffett. From his investment philosophy and the times in which they were formed, through to his philanthropy and how that evolved, the insights that the book provided are significant, fascinating and, with Buffett's recent discussion of the current investment environment, highly relevant.