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Archive for November, 2005

In the opening paragraph of this letter, there’s already a lesson. When looking at the operating earnings of any company, do not take into account the capital gains/losses of its holdings. We will want to evaluate a company based on the earnings from it’s underlying operations.

In the long run however, the aggregate gains or losses will of course be significant.

Another thing is about earnings. Most companies define record earnings as a new high in earnings per share. The point to note is that there is nothing fantastic about higher earnings if the equity base is higher! Even a dormant savings account can do the same because of compounding.

Thus, a more appropriate measure of managerial ability is the return on equity capital.

The third lesson is in the choosing of companies in correct industries. The textile operations continued to struggle even with good management while the insurance business continued to thrive even though a few major mistakes were made.

There was an interesting comment by Warren that the only products of insurance companies are promises. The policies can be copied by anyone, and there’s very little consumer differentiation to protect against competitors. In such a business, the individual managers have a greater effect on the company’s performance.

Warren also spells out his criteria for buying over businesses. The business should be (1) one that you can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.

As most stocks would be held over the long term, do not be overly concerned with just near term earnings or recent trends in earnings when making your stock purchases. If you were buying a whole business, wouldn’t you be more concerned about the long term prospects?

Also, it makes no difference whether you are buying a minority stake or taking over the entire company. After all, you would want the present management to carry on with the wonderful job that they had been doing and not make any changes.

In fact, it is often the case that the stock market offers you chances to make your purchases at a very good (low) prices. If you were to try buying over the whole company, usually you would have to offer fair value (high price).

One very good resource about investment can be found at the Berkshire Hathaway site. There is a wealth of information contained in the letters that Warren Buffett writes to his shareholders every year. I have always wanted to read the whole lot but somehow have not managed to do so.

In my next ‘task’, I will be reading and picking out some key points from all the letters from 1977 to the present. Hopefully, I will be able to put up about one article per week. That alone will take me about 28 weeks!

Just a slight disclaimer though. I will be looking at each letter in the context of the year that it was written. Some of the information or analysis might had been superceded by the events that happened after that year. Eg. accounting changes, etc. So, if you know something that I don’t, please feel free to add on your thoughts in the remarks section.

Well, at least some light refreshments were provided this time round. They must have heard our complaints in the morning. :)

Back to session 4 of the seminar.

When paying for any share, you would want to pay less than the intrinsic value that you have calculated. Why? In the calculation of the intrinsic value, a lot of it is done by estimation and it is impossible to get a ‘correct’ value. The lesser you pay, the higher your margin of safety.

The stock market is just like an auction process. Prices can go rock bottom or sky high. But whatever the price, remember that no one can force you to participate. You always have the choice of bidding or not bidding.

We are then shown a comparision of Warren Buffett 40 years against Lou Simpson’s 25 year investment performance. Lou Simpson manages GEICO Equities and is one of those possible candidates to succeed Warren Buffet.

He has a return of 20.3% versus Warren’s 21.9%. Quite a close match but if we look at just the last 5 years, he has actually outperformed Warren. An interesting observation about Lou’s portfolio is that his top 10 shareholdings are totally different from that of Warren’s.

The lesson to be learned is that copying a winning portfolio is not a guaranteed formula for investment success. At different times of purchase, many factors would be different and the buying decision derived earlier might not hold anymore. Independent thinking is important.

For those who can’t resist a stock tip, one of Warren’s latest acquisitions is Bugweiser. The current share price is actually slightly lower than his purchase price. What are you waiting for? :)

The seminar ended by revealing the winner of the valuation contest. The correct answer was 80 million which Warren paid for Disney. My answer of 71 million was close but not close enough. A student of 21 yrs old actually won the prize with 79.x million. Lucky fellow. His (totally irrational) method of using 30% over book value actually won him the tickets to Ohama!

Ironically, I had read an article on Disney earlier in the morning inside Forbes magazine. What a coincidence!

Overall, I would say that the attending the seminar would be well worth it for those who are starting out in investment. Having the right mindset would save you from a lot of heartache and losses which will surely be more than that five hundred dollars.

For myself, I was a bit disappointed. I had already been a follower of Warren Buffett and I would have expected a bit more for the money that I paid. Oh well, one good thing that came out of it is my decision to start this site. :)

Just a short update on some news before I finish up my review on the seminar.

Buffett cut Berkshire’s foreign-currency forward contracts to US$16.5 billion in September from US$21.5 billion in June.

The company had US$926 million in pre-tax currency losses in the first half, but managed a profit of US$29 million in gains in the third quarter, even as the US dollar strengthened against the euro, yen and British pound. What currency could he have been holding?

For the record, he managed US$2.96 billion of foreign-exchange gains from 2002 to 2004.

Ok. Lunch was much, much better than tea break. At least it was provided. :)

I managed to eat my appetizer of salad and soup, main course inclusive of some seafood and oysters, and dessert of some fruits and pastries. With an extremely full stomach, I proceeded back to the seminar…

Session 3 started with a question, “How much would you pay for a machine that paid you $1 per year for 10 years?” There were different answers from the participants and most answers were within reasonable limits.

Other than using gut feel, this question is actually a simple financial mathematics problem involving the calculation of the present value of a series of cash flows. If you use a reasonable number for the interest rate, you should get a reasonable answer.

In the graph below, the straight line shows the value of a business while the curly lines shows the market value of the same business. What does this tell you?

“When you invest in stocks, always treat them as businesses. Look at market fluctuations as your friend rather than your enemy. Profit from folly rather than participate in it.” Are you an investor or a speculator?

We were then taught Benjamin Graham’s simple formula for calculating the intrinsic value of a stock.

IV = Current Earnings x (8.5 + twice the annual earnings growth rate)

We were shown Robert’s own formula which was slightly modified to take into account the percentage. It didn’t made any sense to me but the calculations worked out fine with his formula. I suspect the Ben’s formula that he gave us wasn’t stated in the original form. Guess I will have to look it up in his book.

Now came to the much awaited part of the seminar. We were given some data and were asked to value a company . The person who got closest to the answer (the price that Warren actually paid) without going over would win a pair of tickets to the next Berkshire annual general meeting. There would even be a visit to one of the companies hosted by Charlie Munger. Wow!

I decided to base my answer using the present value of the earnings for the next 10 years. Time to take out my calculator. Ops..didn’t bring them. Ok, should still be able to survive since Warren doesn’t use any computers too. He uses paper arithmetic or at most just a simple calculator. I can always rely on my handphone then. HOW IN THE WORLD CAN YOU CALCULATE A COMPLICATED FORMULA INVOLVING THE POWER OF TEN USING YOUR HANDPHONE???

“Time’s up. Does anyone need any more time?” Running out of time, I decided to use the simple Benjamin Graham formula. Hmm..the answer seems a bit high and it can’t be that easy. Otherwise, everyone will end up with the same answer. Ok, I will discount it 50% to include the margin of safety. Maybe just add a bit to my final answer in case anyone uses the same method.

I handed in my answer grudgingly and went for the tea break session. They should have given us more time….