Arohan's investing life

Warren Buffett is the super investor of our time and probably the best known investing celebrity. Even a small investment in Buffett’s holding company, Berkshire Hathaway, when Buffett took the helm, would have made any investor a millionaire many times over. In 1965, when Buffett took control of the company, a single Berkshire Hathaway share was changing hands at around $16. Today it trades at $128,000 (and has traded as high as $151,000 in recent past). This is a return of almost 800,000%. A $1000 investment in Berkshire shares in 1965 would be worth $8 million today. This investment has compounded at the rate of 22.7% annually for over 40 years

Alas, Mr Buffett is close to retiring. He has already picked his successor is in the middle of what can be termed as a very keenly watched succession planning exercise where he is slowly disposing off his holdings and therefore relinquishing control of the holding company. He is adamant however, that any successor to his position will continue the invesment philosophy that he espouses. Berkshire Hathaway could still be a good long term hold but a new investor may very well ask the question: are there any other investment similar to Berkshire Hathaway that I can buy now and hold for long term and expect great returns?

Before we attempt to answer this question, we should review what makes Mr Buffett such a successful investor. What makes up his investment strategy? The genius of Buffett does not lie in devising elaborate and highly sophisticated strategies that the hedge funds are so enamored with. He does not seek to take advantage of every sliver of in-efficiency that the market throws up (although that can be a great wealth creation tool in itself: to wit, George Soros). His genius lies in the common sense approach he takes to his investments, the simplicity of it, and immense patience. Most can understand his approach to investing, very few have the patience to sit still and do nothing, which is what is needed to let your investments mature and bear fruit. My take on his approach boils down to 3 simple principles:

1. Pay less than the actual worth
2. Use judicious leverage
3. Wait

Let’s look at these 3 principles in brief detail:

Pay less than the actual worth: This comes to us naturally when we shop. Buying a stock is no different. The problem is that there is no MSRP on the stock price. So how do you judge the worth of the stock or the company you are considering acquiring? We all know the price. Market sets the price. But what is the value or worth of the stock?

To figure this out, one has to almost always look at the assets that the company has. These assets can be in the form of book value, or patents or brands that can be monetized. In rare situations, you may be able to find a company that has more cash (minus debt) on the books than its entire market capitalization (yes, they still exist), in which case it is easy to see that the company’s liquidation value is higher than the stock price. However, in most situations like this you will find that the company has assets that are just not valued correctly (maybe real estate carried at cost where market value may be significantly higher in orderly liquidation) , or may be a de-facto monopoly in an industry that produces ‘basic’ products, or may be brands that can be monetized but the market has not ascribed any value to it. In some variants of these situations, one will find, that the company is priced at such variance to its book not because of its ‘hidden’ assets but more due to visible signs of distress in its business. Is it just incompetent management, that once replaced will go a long way towards restoring the business health? Maybe a temporary slip-up?

Use judicious leverage: To me, this can occur in two distinct manners. First is when you can borrow money with as little risk as possible and use it for investment alongside your own money. Investors can already borrow money on margin for investments, and that is what most hedge funds do, however, that money is not risk-free. For that to be risk-free, your investment will have to be risk free. (Come to think of it, if you can borrow money at low enough interest and invest with a 10×1 leverage in treasuries, you will generate returns that will give any hedge fund a run for its money). What Buffett does is to invest the float generated by its insurance companies (which is excess capital over what is reasonably needed to meet claims). While not completely risk-free, it is pretty close (as long as the insurance business is run profitably). If you own a profitable business, this is akin to taking the free cash flow and using it for investment purposes

The second way that Buffett uses leverage is a bit subtle. He prefers to buy businesses that are scalable with very little additional capital investments. If you are able to buy a company that is profitable today but only uses part of its capacity now, imagine how profitable the company would be if you grow it and start using 100% of the capacity. This is leveraging your existing assets to generate growth. Of course, the company has to be in an industry where such growth is possible (or should have some advantage that it can use to gain market share in a stagnant industry)

Wait: The toughest of it all. If you buy a business at a price lower than its worth, and/or, you buy a business that has a potential to grow without much additional expenditure (growing profit margins), than what you need to do is to give time for the market to realize the true worth of the business and the business to realize its full profit potential. Waiting is an integral part of this investment process. One cannot expect overnight riches this way. The whole investment theses is built around giving the investment time to mature. If one gets bored waiting, find a hobby (like bridge!) or get a day job to pass time or better still, actively participate in the businesses you bought helping them along the path that you envision (tough to do if you only bought a few hundred shares)

A side note: Financial media falls over backwards extolling the virtues of buy and hold method of investment. It is important to realize that a blind buy-and-hold is not a guarantee of investment success. A lot of ground work needs to be done in selecting your investments before the buy-and-hold principle can do its magic

Additional side note: Taxes are a drag on compounding. Dividends are taxed twice. Long term investors should almost always prefer investing in businesses that compound capital internally (meaning, reinvests in growing its business or portfolio) over a business that prefers to pay out dividends, unless in a tax advantaged account.

In Part 2 of this article, we will examine a few investors (and their investment vehicles) against the principles outlined above and see how close they come to matching Warren Buffett. You may be surprised to find that using same/similar principles, one can arrive at a very different investing style and still be very successful. Stay tuned …

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