The Warren Buffett Way / Edition 2

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Overview

A decade has passed since the book that introduced Warren Buffett to the world-The Warren Buffett Way by Robert Hagstrom-first appeared. Since then, Buffett has solidified his reputation as the greatest investor of all time-quietly amassing a multibillion-dollar fortune, despite the wild fluctuation of the markets. Although Buffett has claimed time and again that what he does is not beyond anybody else's competence, some people still do not understand how this value investing legend can consistently perform so well. That's where Robert Hagstrom and the Second Edition of The Warren Buffett Way come in. This completely revised and updated look at the Oracle of Omaha encompasses Buffett's numerous investments and accomplishments over the past ten years, as well as the timeless and highly successful investment strategies and techniques he has always used to come out a market winner.

Rather than presenting Buffett's strategies by stock purchases-as he did in the first edition-Hagstrom makes "Buffett's Way" more accessible to you, the individual investor, by presenting Buffett's basic tenets of investing and illuminating these principles with relevant and up-to-date examples from Buffett's investments, including common stocks, private companies, and high-yield bonds. Standing far above the market madness, this timely guide distills the wisdom and insight of the world's greatest investor. Change is constant, but the investment principles outlined in this book have remained the same. In an environment that seems to favor the speculator over the investor, Buffett's investment advice has proven, time and again, to be a safe harbor for millions of lost investors. No one understands Warren Buffett like Robert Hagstrom, and in the Second Edition of The Warren Buffett Way, Hagstrom will help you-whether you're a seasoned investor or just getting started-understand and employ the investment strategies that have made Buffett so successful for over five decades.

Starting with an investment of only $100, investor Warren Buffett has managed to amass billions by buying pieces of companies and holding on to them. Hagstrom, who has followed Buffett's career since the early '80s, focuses here on his investment strategies and shows how they have evolved over the years. Foreword by Peter Lynch.

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Editorial Reviews

Wall Street Journal
An extraordinarily useful account of the methods of an investor held by many to be the world’s greatest.
John Rothchild
It's first rate. Buffett gets a lot of attention for what he preaches, but nobody has described what he practices better than Hagstrom. Here is the lowdown on every major stock he ever bought and why he bought it. Fascinating. You could even try this at home.
Time
Phil Fisher
In simple language this book tells the rules by which the most successful American stock investor of modern time got that way. It could be a godsend to the legion of unhappy investors who keep floundering because they ignore the basics of major investment success.
Martin S. Fridson
Warren Buffett is often characterized simply as a 'value investor' or a 'Ben Graham disciple.' Hagstrom fills in the rest of the story with some immensely practical pointers on prospering in the market.
Wall Street Journal
. . . an extraordinarily useful account of the methods of an investor held by many to be the world's greatest.
Charles D. Ellis
Warren Buffett is surely the Greatest Investor of this century—not so much because he built a great fortune within a free market as because he has shared his important thinking with us and has openly demonstrated the sagacity and courage so vital to success. Berkshire Hathaway has been my largest, longest investment. Warren has been my best teacher.
John C. Bogle
Robert Hagstrom presents an in-depth examination of Warren Buffett's strategies, and the 'how and why' behind his selection of each of the major securities that have contributed to his remarkable record of success. His 'homespun' wisdom and philosophy are also part of this comprehensive, interesting, and readable book.
Kenneth L. Fisher
Simply the most important new stock book of the 1990s, to date. Buy it and read it.
Forbes
Peter S. Lynch
The Warren Buffett Way outlines his career and presents examples of how his investment techniques and methods evolved and the important individuals in that process. It also details the key investment decisions that produced his unmatched record of performance.
Publishers Weekly - Publisher's Weekly
Starting with $10,000 in 1956 and today worth some $8.5 billion, with significant holdings in Coca-Cola, Capital Cities/ ABC and the Washington Post Company, Omaha, Nebr.-based Buffet is a major player on Wall Street. Financial consultant Hagstrom, who did not interview his subject but obtained permission to quote from his Berkshire Hathaway annual reports, here outlines Buffet's iconoclastic tenets for investing. Unlike many entrepreneurs who take over companies to sell them off in bits, Buffet buys and holds. He rejects the ``efficient market theory''; he doesn't worry about the stock market; and he buys a business, not a stock. He manages with a small staff, no computers and a ``hands off'' strategy. Learning his secrets here, now the rest of us can do a Buffet? Illustrations. Fortune Book Club dual main selection. (Nov.)
Library Journal
Hagstrom, a principal in a Philadelphia investment firm, describes the investment strategies and techniques used by Warren Buffett to realize enormous success as a professional investor. Aiming his analysis at the individual investor, Hagstrom reviews the influence of Buffett's mentors, Ben Graham and Philip Fisher, and illustrates Buffett's synthesis of their investment philosophies. Hagstrom provides case studies of Buffett's major investments, showing the qualities of the companies that had appeal. Buffett's investment philosophy espouses long-term investing, respect for good management, and recognition of the value of a business franchise. This insightful work is a worthwhile complement to Graham's classic writings, considered essential for new investors.-Joseph Barth, U.S. Military Acad. Lib., West Point, N.Y.
David Rouse
Warren Buffett was identified as the richest person in America by "Forbes" last year. Of the more than 70 individuals or families worth more than $1 billion on "Forbes" list, only Buffett acquired his wealth through investing. Hagstrom, a principal at a Philadelphia investment firm, has tracked the success of Buffett for more than 10 years and argues that the same strategies that Buffett uses in selecting acquisitions can be used by individuals in selecting stocks. Buffett's firm, Berkshire Hathaway, has one of the most widely read annual reports issued, with Buffett himself personally contributing advice, humor, and insight. Hagstrom had Buffett's approval in including extensive quotes from these reports, but Buffett cooperated in no other way with this book. Hagstrom examines the influence of Benjamin Graham and his classic "The Intelligent Investor" on Buffett and details what Buffett looks for in his investments. Recommended for libraries with popular investment collections.
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Product Details

  • ISBN-13: 9780471648116
  • Publisher: Wiley, John & Sons, Incorporated
  • Publication date: 10/8/2004
  • Series: Wiley Investment Classic Series , #30
  • Edition description: REV
  • Edition number: 2
  • Pages: 272
  • Product dimensions: 6.36 (w) x 9.31 (h) x 1.01 (d)

Meet the Author

ROBERT G. HAGSTROM is Senior Vice President of Legg Mason Capital Management and the portfolio manager of the Legg Mason Growth Trust. He is a member of the CFA Institute and the Financial Analysts of Philadelphia. The Warren Buffett Way sold more than 1,000,000 copies worldwide and spent twenty-one weeks on the New York Times bestseller list. Robert lives with his family in Villanova, Pennsylvania.
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Table of Contents

Foreword to the second edition
Foreword to the first edition
Introduction
1 The world's greatest investor 1
2 The education of Warren Buffett 11
3 "Our main business is insurance" : the early days of Berkshire Hathaway 29
4 Buying a business 41
5 Investing guidelines : business tenets 61
6 Investing guidelines : management tenets 81
7 Investing guidelines : financial tenets 109
8 Investing guidelines : value tenets 121
9 Investing in fixed-income securities 141
10 Managing your portfolio 157
11 The psychology of money 177
12 The unreasonable man 189
Afterword : managing money the Warren Buffett way 199
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First Chapter

The Warren Buffett Way


By Robert G. Hagstrom

John Wiley & Sons

ISBN: 0-471-64811-6


Chapter One

The World's Greatest Investor

Every year, Forbes magazine publishes a list of the 400 richest Americans, the elite Forbes 400. Individuals on the list come and go from year to year, as their personal circumstances change and their industries rise and fall, but some names are constant. Among those leading the list year in and year out are certain megabillionaires who trace their wealth to a product (computer software or hardware), a service (retailing), or lucky parentage (inheritance). Of those perennially in the top five, only one made his fortune through investment savvy. That one person is Warren Buffett.

In the early 1990s, he was number one. Then for a few years, he see-sawed between number one and number two with a youngster named Bill Gates. Even for the dot-com-crazed year 2000, when so much of the wealth represented by the Forbes 400 came from the phenomenal growth in technology, Buffett, who smilingly eschews high-tech anything, was firmly in fourth position. He was still the only person in the top five for whom the "source of wealth" column read "stock market." In 2004, he was solidly back in the number two position.

In 1956, Buffett started his investment partnership with $100; after thirteen years, he cashed out with $25 million. At the time of this writing (mid-2004), his personal net worth has increased to $42.9 billion, the stock in his company is sellingat $92,900 a share, and millions of investors around the world hang on his every word.

To fully appreciate Warren Buffett, however, we have to go beyond the dollars, the performance accolades, and the reputation.

INVESTMENT BEGINNINGS

Warren Edward Buffett was born August 30, 1930, in Omaha, Nebraska. His grandfather owned a grocery store (and once employed a young Charlie Munger); his father was a local stockbroker. As a boy, Warren Buffett was always fascinated with numbers and could easily do complex mathematical calculations in his head. At age eight, he began reading his father's books on the stock market; at age eleven, he marked the board at the brokerage house where his father worked. His early years were enlivened with entrepreneurial ventures, and he was so successful that he told his father he wanted to skip college and go directly into business. He was overruled.

Buffett attended the business school at the University of Nebraska, and while there, he read a new book on investing by a Columbia professor named Benjamin Graham. It was, of course, The Intelligent Investor. Buffett was so taken with Graham's ideas that he applied to Columbia Business School so that he could study directly with Graham. Bill Ruane, now chairman of the Sequoia Fund, was in the same class. He recalls that there was an instantaneous mental chemistry between Graham and Buffett, and that the rest of the class was primarily an audience.

Not long after Buffett graduated from Columbia with a master's degree in economics, Graham invited his former student to join his company, the Graham-Newman Corporation. During his two-year tenure there, Buffett became fully immersed in his mentor's investment approach (see Chapter 2 for a full discussion of Graham's philosophy).

In 1956, Graham-Newman disbanded. Graham, then 61, decided to retire, and Buffett returned to Omaha. Armed with the knowledge he had acquired from Graham, the financial backing of family and friends, and $100 of his own money, Buffett began a limited investment partnership. He was twenty-five years old.

THE BUFFETT PARTNERSHIP, LTD.

The partnership began with seven limited partners who together contributed $105,000. The limited partners received 6 percent annually on their investment and 75 percent of the profits above this bogey; the remaining 25 percent went to Buffett, who as general partner had essentially free rein to invest the partnership's funds.

Over the next thirteen years, Buffett compounded money at an annual rate of 29.5 percent. It was no easy task. Although the Dow Jones Industrial Average declined in price five different years during that thirteen-year period, Buffett's partnership never had a down year. Buffett, in fact, had begun the partnership with the ambitious goal of outperforming the Dow by ten points every year. And he did it-not by ten-but by twenty-two points!

As Buffett's reputation grew, more people asked him to manage their money. For the partnership, Buffett bought controlling interests in several public and private companies, and in 1962 he began buying shares in an ailing textile company called Berkshire Hathaway.

That same year, 1962, Buffett moved the partnership office from his home to Kiewit Plaza in Omaha, where his office remains today. The next year, he made a stunning purchase.

Tainted by a scandal involving one of its clients, American Express saw its shares drop from $65 to $35 almost overnight. Buffett had learned Ben Graham's lesson well: When stocks of a strong company are selling below their intrinsic value, act decisively. Buffett made the bold decision to put 40 percent of the partnership's total assets, $13 million, into American Express stock. Over the next two years, the shares tripled in price, and the partners netted a cool $20 million in profit. It was pure Graham-and pure Buffett.

By 1965, the partnership's assets had grown to $26 million. Four years later, explaining that he found the market highly speculative and worthwhile values increasingly scarce, Buffett decided to end the investment partnership.

When the partnership disbanded, investors received their proportional interests. Some of them, at Buffett's recommendation, sought out money manager Bill Ruane, his old classmate at Columbia. Ruane agreed to manage their money, and thus was born the Sequoia Fund. Others, including Buffett, invested their partnership revenues in Berkshire Hathaway. By that point, Buffett's share of the partnership had grown to $25 million, which was enough to give him control of Berkshire Hathaway.

What he did with it is well known in the investment world. Even those with only a passing interest in the stock market recognize Buffett's name and know something of his stunning success. In the following chapters, we trace the upward trajectory of Berkshire Hathaway in the forty years that Buffett has been in control. Perhaps more important, we also look beneath the surface to uncover the commonsense philosophy on which he founded his success.

THE MAN AND HIS COMPANY

Warren Buffett is not easy to describe. Physically, he is unremarkable, with looks often described as grandfatherly. Intellectually, he is considered a genius; yet his down-to-earth relationship with people is truly uncomplicated. He is simple, straightforward, forthright, and honest. He displays an engaging combination of sophisticated dry wit and cornball humor. He has a profound reverence for all things logical and a foul distaste for imbecility. He embraces the simple and avoids the complicated.

When reading Berkshire's annual reports, one is struck by how comfortable Buffett is quoting the Bible, John Maynard Keynes, or Mae West. The operable word here is reading. Each report is sixty to seventy pages of dense information: no pictures, no color graphics, no charts. Those who are disciplined enough to start on page one and continue uninterrupted are rewarded with a healthy dose of financial acumen, folksy humor, and unabashed honesty. Buffett is candid in his reporting. He emphasizes both the pluses and the minuses of Berkshire's businesses. He believes that people who own stock in Berkshire Hathaway are owners of the company, and he tells them as much as he would like to be told if he were in their shoes.

When Buffett took control of Berkshire, the corporate net worth was $22 million. Forty years later, it has grown to $69 billion. It has long been Buffett's goal to increase the book value of Berkshire Hathaway at a 15 percent annual rate-well above the return achieved by the average American company. Since he took control of Berkshire in 1964, the gain has been much greater: Book value per share has grown from $19 to $50,498, a rate of 22.2 percent compounded annually. This relative performance is all the more impressive when you consider that Berkshire is penalized by both income and capital gains taxes and the Standard & Poor's 500 returns are pretax.

On a year-by-year basis, Berkshire's returns have at times been volatile; changes in the stock market and thus the underlying stocks that Berkshire owns create wide swings in per share value (see Table 1.1).

To appreciate the volatility, compare the results for 1998 with 1999. In 1998, Berkshire's value increased more than 48 percent. Then, in 1999, Berkshire's increase dropped to a paltry 0.5 percent, yet the S&P 500 increased 21 percent. Two factors were involved: Berkshire's results can be traced to poor return on consumer nondurables (Coca-Cola and Gillette), while the S&P increase was fueled by the outstanding performance of technology stocks, which Berkshire does not own.

Speaking with the candor for which he is famous, Buffett admitted in the 1999 annual report that "truly large superiorities over the [S&P] index are a thing of the past." He predicted, however, that over time Berkshire's performance would be "modestly" better than the S&P. And for the next three years, this turned out to be the case. Then in 2003, even though Berkshire had a terrific year-book value up 21 percent-the S&P did even better.

BUFFETT TODAY

Over the most recent years, starting in the late 1990s, Buffett has been less active in the stock market than he was in the 1980s and early 1990s. Many people have noticed this lack of activity and have wondered whether it signaled that the market had hit its top. Others have theorized that the lack of new major purchases of common stocks simply means that the type of stocks Buffett likes to purchase are no longer selling at attractive prices.

We know it is Buffett's preference to "buy certainties at a discount." "Certainties" are defined by the predictability of a company's economics. The more predicable a company's economics, the more certainty we might have about its valuation. When we look down the list of stocks that Buffett owns as well as the wholly owned companies inside Berkshire, we are struck by the high degree of predictability reflected there. The "discount" part of the statement obviously refers to the stock price.

Knowing that Buffett likes to buy highly predictable economics at prices below the intrinsic value of the business, we can conclude that his buyer's strike reflects the lack of choices in this arena. I am pretty sure that if Coca-Cola, Gillette, or other similar businesses were today selling at fifty cents on the dollar, Buffett would add more shares to Berkshire's portfolio.

We also know Buffett's discipline of operating only within his "circle of competence." Think of this circle of competence as the cumulative history of your experience. If someone had successfully operated a certain business within a certain industry for a decade or more, we would say that person had achieved a high level of competence for the task at hand. However, if someone else had only a few years' experience operating a new business, we could reasonably question that person's level of competence. Perhaps in Buffett's rational mind, the sum total of his business experience in studying and operating the businesses in Berkshire's portfolio sets the bar of competence so high that it would be difficult to achieve a similar level of insight into a new industry.

So perhaps Buffett faces a dilemma. Within his circle of competence, the types of stocks he likes to purchase are not currently selling at discounted prices. At the same time, outside his circle of competence, faster-growing businesses are being born in new industries that have yet to achieve the high level of economic certainty Buffett requires. If this analysis is correct, it explains why there have been no new large buys of common stocks in the past few years.

We would be foolish indeed to assume that because the menu of stocks available for purchase has been reduced, Warren Buffett is left without investment options. Certainly he has been active in the fixed-income market, including taking a significant position in high-yield bonds in 2002. He is alert for the periodic arbitrage opportunity as well, but considering the amount of capital Buffett needs to deploy to make meaningful returns, the arbitrage markets are perhaps not as fruitful as they once were.

But Berkshire Hathaway shareholders should not feel they are being deprived of opportunities. Too often, shareholders forget one of the most important owner-related business principles Buffett outlines each year in the annual report. The fourth principle states, "Our preference would be able to reach our goal [of maximizing Berkshire's average annual rate of gain in intrinsic value] by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses attained primarily through the purchases of marketable common stocks."

In Berkshire's early years, owning common stocks made the most sense economically. Now, as common stock prices have risen dramatically and the purchasing power of Berkshire's retained earnings has mushroomed, the strategy of buying whole businesses, which is Buffett's stated preference, has come to the forefront.

There is a personal factor as well. We know that Buffett greatly enjoys his relationships with his operating managers and takes a great deal of pride in Berkshire's collection of operating businesses. Conversely, the angst he has endured by being a shareholder of publicly traded companies, with the issues of executive compensation and questionable capital reinvestment strategies that accompany ownership, may make being a shareholder less appealing for Buffett today than it used to be. If the economics are not compelling, why would Buffett choose to endure the corporate governance fiascos associated with being a major shareholder?

The only activity Buffett involves himself in with Berkshire's operating businesses is setting executive compensation and allocating the profits. Inside Berkshire's world, these decisions are highly rational. Outside in the stock market, management decisions on executive compensation and capital reallocation do not always reflect rationality.

What does this mean for individual investors? Because Buffett is not actively involved in the stock market, should they automatically pull back as well? Buffett's alternative strategy is to buy businesses outright, an option that is out of reach for most investors. So how should they proceed?

There appear to be two obvious choices.

Continues...


Excerpted from The Warren Buffett Way by Robert G. Hagstrom Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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