Warren Buffett’s Investment Strategy – Part 1

October 16, 2012 — 1 Comment

Some people classify Warren Buffett’s investment stages based upon company’s organizational forms and business models. Based upon this classification, Warren Buffett’s first stage was when he had a partnership in the 1950s and 1960s. His second stage would be in the 1980s and 1990s, where he used his company Berkshire Hathaway as his investment vehicle.

However, it would be more accurate to divide Buffett’s investment stages based on the evolution of his investment philosophy.

First Stage – Value Investing (1949 – 1971, 19-41 years old)

  1.  This phase is marked by the teachings of Warren Buffett’s teacher at Columbia University – Ben Graham, and of the teachings of Graham’s books e.g. “The Intelligent Investor”.
  2. Ben Graham, preached “the margin of safety” (a.k.a. value investing).
  3. Basic concept: Buy $1 of an undervalued stock for 40 cents. Think of the stock as a portion of a company. The “margin of safety” is in the fact that you’re buying $1 worth of stock for 60 cents cheaper. In essence, buy a company’s stock for less than what ALL ITS ASSETS are worth.
  4. Prior to this, Warren Buffett based his investment decisions on his gut feeling (discretionary investor/trader), but this opened up a formulaic (systematic) way to invest. For this entire First Stage, Buffett practiced Graham’s investment style.
  5. At age 20 in 1950, Buffett learned from Graham (who was a successful fund manager) at Columbia.
  6. He worked for Graham’s fund by the time he was 24, and left to create his own fund by the time he was 26 in the mid 1950s.
  7. Buffett applied this approach to his fund very well, and made returns in excess of 30% a year.

Now why would a stock be undervalued (on the stock exchange, be priced at less than all that it’s assets are worth)? 1 of 2 things can happen:

  1. Market crash, people panic, people don’t think logically (happens all the time), herd mentality, depress the stock price
  2. Underscrutinized market.

In the first stage, Buffett’s strategy of value investing was divided into 3 subcategories:

  1. General undervalued investment.
  2. Control an undervalued company. Buy enough shares to control the company’s management decisions. The profits from such investments (e.g. force it to declare dividends) have no relationship with the stock price’s performance on the market.
  3. Arbitrage (2 different markets posting different prices for the same stock, buy the stock from the cheaper exchange and sell it on the more expensive exchange).

The first and second subcategories are often connected. E.g. if an undervalued investment is very low, he’d buy a Controlling stake in the company, which means his profits wouldn’t come from the stock price but from e.g. forced dividends. But if the once-undervalued investment was at a high price, he could sell it and profit from the high stock price. A profitable double edged sword.

In addition, the first subcategory is split into another 2 subcategories:

  1. General undervalued stock owned by private, small investors. These can be converted into a Controlled company.
  2. General undervalued stock owned by large, institutional investors. These can’t be converted into a Controlled company b/c the stock has such a large market cap. E.g. American Express in the 1960s.

Example Companies

  1. 1955: Decided to buy Union Street Railway – bus company that had buses, cash, real estate. Assets worth $65 a share, stock selling at $35 bucks a share. Warren bought as much as possible. Company declares $50 dividend, Warren almost doubles his money, and still owns a portion of the company’s value (via stock).
  2. National American – 1956: doesn’t say how much assets (but must be over $100), making $30 in profits a year, shares selling for $30.

Transition Stage

The big reason why “value investing” worked so well in the 1950s and 1960s was that prior to this era, it was the Great Depression, which vastly depressed stock prices. Stocks took a long time to come out of this pit, which meant that all the way towards the end of the 1960s, there were many vastly undervalued stocks.

By mid 1960s, Buffett noted a key problem in Graham’s value investing strategy. Opportunities to buy cheap stocks were becoming fewer and fewer as the market rose. Whereas in the past he preferred General Undervalued Stock Owned by Private, Small Investors, now he starts to shift towards General Undervalued Stock Owned By Large, Institutional Investors (e.g. American Express). Large stocks tend to be suddenly undervalued due to a crisis, which happened to American Express in the 1960s. Buffett saw that the crisis was being blown to extraordinary proportions, so he bought AE stock, which rose five-fold in 5 years.

This change demonstrated a transition between Buffett’s First Stage and Second Stage. The transition was slow because for the 1950s and most of the 1960s, there still were investment opportunities in undervalued stocks. When these disappeared by the beginning of the 1970s, Buffett coincidently read a book describing Growth Stocks, which resulted in his Second Stage of investment strategy.

Question I’d Like You to Ask Yourself

Using this philosophy, would you buy stock: (and why, or why not)

  1. Apple (assets = $162 billion, liabilities = $51 billion, net balance = $111 billion, valuation = $611 billion)
  2. Coca-Cola (assets = $85 billion, liabilities = $53 billion, net balance = $32 billion)
  3. Google (assets = $72 billion, liabilities = $14 billion, net balance = $58 billion)

Conclusion

  1. Undervalued stocks usually aren’t big stocks, because big stocks are heavily scrutinized.
  2. The era of value investing is over, unless a market crash comes along which depresses the market as a whole

One response to Warren Buffett’s Investment Strategy – Part 1

  1. your right this siuation would never happen unless this recession prolongs itself and we have another depression, which should depress stock prices for a long time

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