Warren Buffett way
The Warren Buffet Way is a book by Robert Hagstrom. He describes the influences to warren Buffet:
- Benjamin Graham, a number oriented analytical investor, oriented towards low price stocks
- Phil Fisher: an investor from the 30s who studied accounting and advocated “scuttlebutt” the collection of all possible data about a company. Fisher concentrated his bets on less than 10 stocks with 75% of positions often in 3 stocks.
- Charlie Munger: an investor working in LA who became partner to WB in the 60s. Munger taught buffet that a great business at a fair price can be a lower risk than a terrible price at bargain price
The 12 tenets for business are:
- is business simple and understandable?
- does the business have a consistent operating history?
- does the business have favorable long-term prospects?
- Is management rational?
- Is Management candid with its shareholders?
- does management resist the institutional imperative?
- focus on return on equity, not earning per share
- calculate owner earnings
- look for companies with high profit margins
- for every dollar retained, make sure the company has created at least one dollar of market value
- What is the value of the business?
- Can the business be purchased at a significant discount to its value?
The institutional imperative is the tendency for businesses to invest in the current thing, do like the rest of the industry irrespective of whether it makes sense.
Owner earnings are operating cash-flows with correct depreciation based on replacement cost amortization required to maintain the activity. Some capital intensive plants have old infrastructure with low depreciation due to inflation, so the numbers need to be checked.
cost cutting programs are indicia of corporate conspicuous consumption.
similarly, management effectiveness includes the increase of market value given retained earnings.
Hagstrom makes the point that Buffet, like Fisher, thinks that portfolios should be focused rather than diversified. I don’t think this is born by statistical evidence.
He makes the following interesting expertement out of 1200 stocks for the period 1987-1996
- 3000 portfolios of 250 stocks, 0.65% sd, 11.4% to 16% perf, 63 beat the mkt
- 3000 portfolios of 100 stocks, 1.11% sd, 10% to 18.3% perf, 337 beat the mkt
- 3000 portfolios of 50 stocks, 1.54% sd, 8.6% to 19.1% perf, 549 beat the mkt
- 3000 portfolios of 15 stocks, 2.78% sd, 6.75 to 26.6% perf, 808 beat the mkt
I assume that the market is the cap weighted performance of the 1200 stocks. That the market beats random portfolios means that there was over performance by large cap over small cap.
He communicates best and worst performance and standard deviation of return but no mean or median portfolio performance (which is key to understanding why beating the market was hard on average). Also, he did not test the 3 stocks portfolio that Fisher or Buffet had for a while. A 1 to 3 stock portfolios set would have massive return variance.
Buffet Way vs Statistics
Advocating that people use a very focused/high noise portfolio would result in half of the unskilled people believing they are skilled due to overperformance at the end of a few year period, and half the people who are skilled believing the opposite. Therein lie a problem, that the author does not consider what it takes to confirm that one is skilled.
Restricting one’s circle of competence leads to restricted investment domain and inferior performance fo all those but the lucky few who had the right circle. Superior performance can be achieved by developing one’s edge in the most promising field. The Fisher approach was developped in pre-internet age, it is described like a seat-of-the-pants “what worked for me” receipe rather than an optimized, cross-validated method.
Warren Buffet explains that focused portfolio make sense and diversification is for know-nothing investor. Indeed, if stock returns are known to you with certainty, it makes sense to focus a portfolio. But this is not what Warren Buffet practiced: the cigar butt strategy chosen in the 60s was high risk as he self-admittedly found out: after much success he ended up with a concentrated bet into a failing textile mill business. It is not clear whether he was constrained to few bets by research capacity or by the lack of opportunity in the market. He might have taken too concentrated bets given the risks.
If one makes 100 uncorrelated bets per year, one can compute with some margin of certainty the accuracy of your bets. If you make 3 bets per year, it will take you 30 year to obtain similar information about your accuracy. It seems that Warren was running too few positions before he obtained sufficient data to assert that he had an edge, so he got lucky and the number of bets he made only allowed him to improve his investment strategy after more than a decade.