Warren's Way
Christopher Scibelli
>I recently read _The Warren Buffett Way_ and I'm a believer. I plan
>on using this book as my investment "Bible".
I wouldn't use that book as a investment "Bible," but as kindling.
If you start discounting earnings at the risk-free rate, which this
author advocates, you're heading for the poor-house. The book makes
it simple, but even after you arrive at a proper discount rate you
still have to determine what numbers to use for future earnings. Your
accuracy in predicting future growth rates is the chief determinant in
how well you'll do and that involves a lot of guess work and
assumptions. Aside from reading this guy's book I've also seen him
interviewed on Tv. I came away underwhelmed. BTW, if you really have
faith in this author he has started a mutual fund you may wish to
consider. My recomendation for a "Bible" is "The Intelligent
Investor" by Benjamin Graham. He was Buffett's mentor and this will
have to suffice till WB writes a book.
Chris
----------------------
scib...@ix.netcom.com
sjs...@delphi.com
Paul Randolph
weeny little problem. I don't understand most of the terms. The
book talks about "owner earnings" "retained earnings" and "operating
earnings". Actually figuring out these is the easy part. The hard
part is picking up an annual report and figuring out which numbers
fall into which of Buffett's categories. For example, is foreign
excise tax classified as "other non-cash charges"? I don't have a
clue.
At this point, please don't want answers my questions above--I'm only
interested in seeing who wants to join an ongoing discussion about
understanding Warren's Way to the point where we can actually PUT IT
INTO PRACTICE.
Anyone who's interested, raise your hand (or send me some e-mail).
I guess we'll have to cc our e-mail messages. It's not ideal but
it gets the job done.
Well? Any takers?
Paul Randolph <geh0...@niftyserve.or.jp>
Brendan E. O'Connor
: Paul Randolph <GEH0...@niftyserve.or.jp> wrote:
: >I recently read _The Warren Buffett Way_ and I'm a believer. I plan
: >on using this book as my investment "Bible".
: I wouldn't use that book as a investment "Bible," but as kindling.
I disagree, Chris. While no book written by one person about another's
thinking process, especially without collaboration, can be perfect, I
think there is value in the outline Mr. Hagstrom has presented. I too
would like to debate some of the fine points of what he presented and
some of the details he glossed over. I also agree that the book can be
misleading in that it makes the process look too easy for those who haven't
tried it, but I do find it useful as an addition to the value investing
literature.
: If you start discounting earnings at the risk-free rate, which this
: author advocates, you're heading for the poor-house. The book makes
: it simple, but even after you arrive at a proper discount rate you
: still have to determine what numbers to use for future earnings. Your
: accuracy in predicting future growth rates is the chief determinant in
: how well you'll do and that involves a lot of guess work and
: assumptions.
I agree it isn't easy, but don't you agree that discounting future owner
earnings is a valid way to value a company? As a value investor I only
know to buy marketable assets owned by a company or the future earnings
expected from its assets. Usually it's the earnings I'm buying. To
do this I estimate the future earnings and discount them to present
value. How do *you* value companies?
: Aside from reading this guy's book I've also seen him
: interviewed on Tv. I came away underwhelmed. BTW, if you really have
: faith in this author he has started a mutual fund you may wish to
: consider.
I agree that the book isn't enough for me to be overly impressed with the
author. Any good journalist could have done what he did--most probably
better. I don't believe that you can become a skilled value investor by
studying Warren's writings and summarizing them in a book. I was amused
when I heard that he started a fund after writing the book, as if that
was enough for him to know what he's doing. On the other hand, most fund
managers make more money via marketing than by earning money for their
shareholders, and he'll probably make good money taking advantage of the
publicity from the book. I would not put any money into Mr. Hagstrom's
fund unless he has some other credentials besides having written this
book *and* a track record.
: My recomendation for a "Bible" is "The Intelligent
: Investor" by Benjamin Graham. He was Buffett's mentor and this will
: have to suffice till WB writes a book.
Another of many good sources of knowledge for value investors.
: Chris
:
: ----------------------
: scib...@ix.netcom.com
: sjs...@delphi.com
I appreciate someone starting a discussion which has more to do with
developing our fundamental understanding than with catching the next
5-point move in the latest hype stock. Let's do this again soon.
Brendan
--
Brendan O'Connor
Indianapolis, IN
b...@indy.net
Christopher Scibelli
Brendan.
>I agree it isn't easy, but don't you agree that discounting future owner
>earnings is a valid way to value a company?
Sure, if you think you're able to estimate those future earnings.
>As a value investor I only
>know to buy marketable assets owned by a company or the future earnings
>expected from its assets. Usually it's the earnings I'm buying. To
>do this I estimate the future earnings and discount them to present
>value. How do *you* value companies?
I don't use one method to pick stocks, but I either estimate earnings
at some point in the future and multiply by a projected P/E ratio, or
I buy a stock as an asset play. Two examples from the former method
are Microsoft and Pier 1. I bought Microsft in 1990 and it has worked
out well because my earnings estimates proved to be too conservative
and the P/E has expanded. I bought Pier 1 2 1/2 years ago, and
although it has risen, I didn't anticpate the charges they took in
each year and it has lagged the market. Asset plays would be a local
Savings and Loan that converted to a Stock S&L. At 65% of book I felt
it was undervalued since comparable thrifts in this State were selling
at 105% of book. It has doubled in 10 months. Sears is another asset
play which has done well. I have had asset plays that went nowhere
because management never unlocked the value. Westinghouse is a good
example of this.
I'd like to read how you do it. Same for anyone else.
Chris
----------------------
scib...@ix.netcom.com
sjs...@delphi.com
Braden Glett
discounting earnings at the risk-free rate, thus proving that he knows
very little about financial theory. Chris Cox had the best advice: learn
financial theory from the ground up so that you have a foundation to
build upon.
The bit about using the risk-free rate to discount non-risk free earnings
streams is a good example of "you can't believe everything you read."
Unless you have foundation to build on, you have no basis for being able
to spot a fundamental flaw like the one in his book.
The keys to value investing have very little to do with discounting the
earnings, anyway. That part is simple. The hard part is learning how to
spot commonly accepted perceptions as bogus. A good example was Phillip
Morris a few months ago. Common wisdom was that tobacco is doomed. I just
knew that couldn't be correct, or if it was, it was far further in the
future than what the market was assuming. Another area earlier this year
was "uncompetitive" high-cost electric utilities, priced as if they were
going to be out of business within two years.
If you get good at spotting areas that the public is "afraid" of, and buy
them once they begin acting well again technically, you won't need to
worry too much about dividend models, CAPM, etc. Don't buy them while
they are in a free-fall, however, or you may have to dig out of a big
hole before making any money, or you may be just plain wrong and lose a
lot. Even a value investor needs to pay attention to timing.
Thanks
Brady
Brendan E. O'Connor
: It's interesting to note that the author of the WB Way advocates
: very little about financial theory. Chris Cox had the best advice: learn
: financial theory from the ground up so that you have a foundation to
: build upon.
: The bit about using the risk-free rate to discount non-risk free earnings
: streams is a good example of "you can't believe everything you read."
: Unless you have foundation to build on, you have no basis for being able
: to spot a fundamental flaw like the one in his book.
Braden,
First, the author of this book is not advocating anything, he's simply
reporting his best interpretation of what Warren Buffett does. Notice
this is not what Warren Buffett advocates that others do either, it is
what *he* does. What he would advocate others do probably would depend
on his assessment of their knowledge of business and their decisionmaking
skills, as well as probabably some other things--including the types of
securities they are going to buy.
I agree, you need to know financial theory to know when you can apply
Buffett's methods and when you can't. For example, you can only use the
risk-free rate for comparison if the risk of your future owner
earnings estimates being wrong is near zero. This is what Buffett
assumes, according to Hagstrom. Neither is recommending that others use
the risk-free rate for discounting. Neither of them knows how certain
you are about your earnings projections.
I would also agree that Buffett may be making an inappropriately extreme
statement here. I don't know that he really thought that the future
earnings of US Air were certain when he bought it. Although, some of his
ideas--Wash. Post, Coca Cola, UST Inc., GEICO--do come pretty close to the
ideal. The point is that he uses the risk-free rate because he assumes
the risk of his being wrong about future earnings is close enough to zero.
Please read page 94 of Hagstrom's book again. I don't think he's
"advocating" use of the risk-free rate, just reporting what Buffett has
said. Here's an excerpt:
"Many people will be surprised to learn that the discount rate that
Buffett uses is simply the rate of the long-term U.S. government bond,
nothing else. That is as close as anyone can come to a risk-free rate.
"Acacemics argue that a more appropriate discount rate would be
the risk-free rate of return plus an equity risk premium, added to
reflect the uncertainty of the company's future cash flows. Although
Buffett does admit that as interest rates decline he is apt to be more
cautious in applying the long-term rate, he does not add a risk premium
to his formula for the simple reason that he avoids risk....business
risk is reduced, if not eliminated, by focusing on companies with
consistent, predictable earnings. 'I put a heavy weight on certainty,'
he says. 'If you do that, the whole idea of a risk factor doesn't make
any sense to me. Risk comes from not knowing what you're doing.'"
And on page 90:
"Owner earnings, Buffett admits, do not provide the precise calculations
that many analysts demand. Calculating future capital expenditures often
requires rough estimates. Still, quoting Keynes, he says, 'I would
rather be vaguely right than precisely wrong.'"
It may look like these two excerpts contradict each other. Maybe they
do. One way to eliminate the contradiction is to use worst-case owner
earnings estimates that you are very certain of. The difference between
accuracy and precision also comes into play here.
Brendan E. O'Connor
: b...@indy.net (Brendan E. O'Connor) wrote:
: Brendan.
: >I agree it isn't easy, but don't you agree that discounting future owner
: >earnings is a valid way to value a company?
: Sure, if you think you're able to estimate those future earnings.
: >As a value investor I only
: >know to buy marketable assets owned by a company or the future earnings
: >expected from its assets. Usually it's the earnings I'm buying. To
: >do this I estimate the future earnings and discount them to present
: >value. How do *you* value companies?
: I don't use one method to pick stocks, but I either estimate earnings
: at some point in the future and multiply by a projected P/E ratio, or
: I buy a stock as an asset play.
Except when the greater fool theory is assumed, companies don't sell for
a multiple of this year's earnings, but for the future earnings that this
year's earnings imply. When you project what a company will earn some
year in the future and assume a p/e ratio multiplier to estimate the
price, you are assuming that the market will buy because the market
expects the earnings trend to continue. You are implicitly either
estimating future earnings or estimating what the market will estimate
future earnings to be.
As a value investor, I try to estimate the real economic earnings and,
unless there are special circumstances, assume that the market will
someday be willing to pay for the real earnings. I think it's dangerous
to play the greater fool game, since it's based on perception, not
reality. That said, I know that there are people who can make a lot of
money betting on perceptions and I don't deny that that's a way to make
money. I just don't think it's the best way for me.
It sounds like you're trying to do the same thing I am, you just use
different indicators of value and have described the strategy in a
different way.
BTW, I do a lot of thinking about the theory and real economics behind
what I'm doing. I still have a lot to learn. Sometimes I temporarily
get too deep into the theory and make mistakes that a simpler view of the
situation would have helped me avoid--something like missing the forest
for the trees. I'm really more driven by learning about business and
microeconomics than I am by making money. Your way of thinking about it
probably works better most of the time because it keeps you better
focussed on the most critical issues.
: I'd like to read how you do it. Same for anyone else.
: Chris
:
Jon Solworth
> From: b...@indy.net (Brendan E. O'Connor)
> Newsgroups: misc.invest.stocks
> Date: 18 Oct 1995 16:14:38 GMT
> Organization: IndyNet - Indys Internet Gateway (in...@indy.net)
>
> I agree, you need to know financial theory to know when you can apply
> Buffett's methods and when you can't. For example, you can only use the
> risk-free rate for comparison if the risk of your future owner
> earnings estimates being wrong is near zero. This is what Buffett
^^^^^
> assumes, according to Hagstrom. Neither is recommending that others use
> the risk-free rate for discounting. Neither of them knows how certain
> you are about your earnings projections.
It is not necessary to compute owner's earnings correctly, only conservatively.
Hence, almost all surprises are upside surprises, increasing the value of
your investment. Of course, the better you understand the company and the
more predictable the company is, the more accurate is your value calculation.
(the more predictable the company is, the closer its discount rate is to
the risk free rate).
The goal is then to find the company whose intrinsic value is
significantly larger than its market value. More accurate estimates,
enable more optimal investments.
Jon
--
_______________________________________________________________________________
Jon A. Solworth internet: solw...@parsys.eecs.uic.edu
Dept. of EECS (M/C 154) url: http://www.eecs.uic.edu/~solworth
University of Illinois at Chicago telephone: (312) 996-0955
851 S. Morgan Rm 1120 SEO FAX: (312) 413-0024
Chicago, IL 60607-7053
Brendan E. O'Connor
: So you actually project earnings out 20 or more years, apply a
: discount rate and get a present value? If so, how long have you been
: doing this and how accurate have your earnings projections been?
...
: Anyway, I suspect we're doing the
: same thing. I estimate earnings and p/e's 5 years out and compare the
: projected price to today's to decide if the risk is worth the
: potential reward and you seem to be using the classical book formula.
: I think some math whiz may say that they are one and the same.
I try to predict earnings out as far as I can. This is based on my
judgement of how certain I can be about the future. As has been stated
elsewhere in this thread, one only needs to be certain about the worst
case scenario, not the most likely. When it makes sense I look at two
stages: a 10-year horizon plus years 11 to infinity, usually assuming a
significantly slower growth rate after year 10. I assume I'll be able to
sell the stock at the end of year 10 for the value of the earnings
accumulated in years 1-10 plus the value of the earnings for years 11 to
infinity, all discounted to present value. I also calculate the ROI for
those cash flow streams.
As I said, I only use this time horizon when it makes sense, which is
almost never. But--the point is that when it does make sense you have a
company with VERY consistent earnings. The only two I've put into this
formula lately that I think really fit are Wal-Mart and UST Inc.
I do this on an Excel spreadsheet which is set up to do the same thing
for 4 years and 7 years as well as for 10 years. As with any technique
that purports to predict the future, I know my estimates will be
inaccurate to some extent. But I don't know any other way to predict the
value of a company in the future except to try to predict either its
earnings or the timing of distributions of assets (or their realization
in the stock price).
I agree that I think we're both doing the same thing. And we're both
making a judgement about how far into the future we can predict what
earnings will be, or at least what the worst-case earnings will be. I
think you'll also agree that how far into the future earnings can be
predicted is a function of the type of company we're looking at. Part of
the judgement that goes into these analyses is judging how far you can
really see into the future. I try to do a lot of sensitivity analyis and
one aspect is how sensitive my numbers are to my judgement on this
issue. In other words, I look at the 4 year, 7 year, and 10 year
assumptions and if I really have to be right for 10 years in order to
make any money, I consider that in estimating the risk I'm bearing.
Brendan
Trader Jack
>If you get good at spotting areas that the public is "afraid" of, and buy
>them once they begin acting well again technically, you won't need to
>worry too much about dividend models, CAPM, etc. Don't buy them while
>they are in a free-fall, however, or you may have to dig out of a big
>hole before making any money, or you may be just plain wrong and lose a
>lot. Even a value investor needs to pay attention to timing.
Brady, you are one value oriented investor that makes emminent sense!
Catching a falling knife only serves to slice up the catcher. I'm
continually amazed at the depth and ferocity of some of the free falls
we see in various stocks from time to time. What appears underpriced
often becomes more underpriced later. Contrarily, if one gets a solid
handle on company fundamentals and then pays attention to some important
timing techniques, efficient investment of one's money can result!
Value investors tend to eschew timing causing their overall performance
to suffer. Momentum investors tend to throw caution to the wind,
thereby getting smacked because they don't understand the fundamental
reasons for a stock's behavior. However, those of us who merge the best
of both methods find lower risk, higher rewarding situations than
momentum players. We also reap the rewards more quickly (efficiently)
than straight value players.
Having said that, I'd be interested in any comments you have on APCC
should they post quarterly earnings higher than current market
expectations (which ain't much at this point!).
Regards,
Trader Jack.
Trader Jack
>Kmart is a case in point. It showed up on my value screens about 2
>years ago at $18. Since then the dividend has been cut, massive
>charges have cut the book vlaue, and it's down 50%. The only thing
>that stopped me from buying it then was gut instinct. There's no rule
>that says a cheap stock can't get cheaper; they usually do! You have
>to able to sort the wheat from the chaff with value stocks.
Yup, you're right. Many examples of the cheap getting cheaper. I
remember back in the "old days" when I was on Prodigy there was some gal
touting Value Merchants' stock. They had dropped from $30 down to the
mid teens--a real knife blade. She was convinced this was a great value
play and was trying to allay the fears of other Value Merchants stock
holders participating in the topic. I told her she should wait for the
company to at least stabilize financially (arrest the negative EPS
acceleration) before committing more money to the position. I myself
wouldn't have touched that stock except to short it on rebounds (I
decided simply to stay away from it--too bad!). Anyway, Value Merchants
fell to $2 before being delisted. If I remember right, they were
cooking their books. Apparently, any value that existed with that stock
was simply an illusion.
There are times where precipitous stock price drops are overdone, but
more than likely these declines do not get corrected immediately. There
is always time to take stock of the situation to decide if the
fundamentals are headed for the tank. If not, then I see no big deal in
waiting for a technical trading bottom to develop before entering a
position. Who knows...in the meantime something better may actually
come along.
Regards,
Trader Jack
Paul Chapman
around 10, while they are currently selling at leading P/E values around
15. Three examples include Sara Lee, Campbell Foods and Heinz. All are
selling at about 50% above what we estimate as fair value.
Paul Chapman, Editor
PEcom Stock Valuation newsletter
"PEcom is our estimate of a 'fair' P/E value"
CJX...@prodigy.com (Braden Glett) wrote:
>Chris Scibelli:
>
>Amen on the use of the risk-free rate to discount earnings. I wonder
>where the guy that wrote the Warren Way got his finance degree?
>
>For a Bible, I would use, well...the Bible.
>
>For an investment tome, I agree Graham's book is good - if more people
>thought like him now they wouldn't be paying 20X earnings for slow-
>growing food companies, etc. as folks are now. I bet Ben wouldn't be too
>comfortable in today's pricey market. I'm not.
>
>Brady
>
Braden Glett
>Having said that, I'd be interested in any comments you have on APCC
>should they post quarterly earnings higher than current market
>expectations (which ain't much at this point!).
>Regards,
>Trader Jack.
Jack, first of all thanks for the kind words. With regard to APCC, I
first want to say that I seldom try to understand the fundamentals of
TECHNOLOGY companies. The reason I do not is because given the lack of
stability in market positions, products, and the technology involved,
understanding the fundamentals can only be done in a very short-term
manner. Therefore, it does not give a lot of comfort for a long-term
holder who cannot afford to keep up with the tech changes. To those who
can understand and follow the changes, my hat is off to them. So for
techs I rely soley on trend-following and gradual entry into a position
as a way to manage risk.
With regard to non-technology companies, I do often try to understand
their market position, etc because brand loyalty, market share, etc are
much more stable. I could list many tech companies of yesterday that were
market leaders but lost that position in a short period of years. On the
other hand, Phillip Morris still has the dominant brand position in
Marlboro that they had ten years ago, and probably ten years from now as
well. Ditto KO, PG, etc.
Having stated that, I looked at the technical position of APCC. It’s
movements over the years have tended to move on a +/- 3.0 std deviations
envelope around a 50-week moving average. It is at the bottom of this
channel now, meaning it has a decent chance of increasing from here.
However, this type of trading works best when the moving average is
trending upward, not downward as it is with APCC now. Net, I would not
buy it because you can find a better bet elsewhere. Also, I could not
give you a reliable loss-cutting strategy for this type of trade, a
necessary element for any trade.
I try to find stocks that have everything going for them, rather than
falling in love with a particular stock and trying to time its every move.
If you’re into technology cos., you should look for a stock that is
making a new high on a upward surprise earnings report and start scaling
into it little by little as it moves up. Make sure each successive buy is
smaller than the last one. Sell when it falls below its 50-week MA. Last
Thursday I did this with CUBE, but it has gone up 20% since then so I’m
not sure whether it would be prudent to start with that one now. Hewlett-
Packard or Cabletron Systems might be a better pick at this point.
But whatever you do, scale in little at a time and cut your losses if the
stock sags down to the 50-week MA. You never know how much you will lose
by hanging on.
Best of regards and God bless,
Brady