Secret #3: Scan thousands of stocks looking for screaming bargains
ONLY A HANDFUL of outsiders have been permitted to enter the inner sanctum of the Berkshire Hathaway offices in Kiewit Plaza, Omaha. When Chris Stavrou, the founder of the New York asset management firm, Stavrou Partners, visited the offices he reported seeing hundreds of file drawers full of reports on thousands of companies.
Two things stand out. Firstly, Buffett said that the reports were mainly annual and quarterly reports. In other words, material that is available to everyone. Secondly, he declares that he does not use a computer. Not even a calculator.
He is able to do without these standard aids since, as many people have attested, he has a prodigious memory. There are numerous examples of him being able to recall obscure facts about the companies that he has investigated, and their competitors, many years later. It seems that he has read, and memorized, a huge amount of the material in the filing cabinets.
This means that, when he is looking for quality investments satisfying his stringent criteria, he can scan through his own memory and couple the results with current prices. In the end, he is not looking for investments that are, with a little luck, likely to be slightly better than average. He wants them to be great investments by a large margin. “If (the investment) doesn’t scream at you,” he once said, “it’s too close.”
Few people have a memory to match Buffett’s. Even fewer have the resources to collect and index tens of thousands of documents on thousands of companies.
Secret #4: Calculate how well management is using the money they have
HOME BUYERS UNDERSTAND about equity. It is the value of the home less the amount owed to the bank. The same is true of a business. Its equity is the total assets minus all the liabilities. You can think of this as the money locked up in the business. It is a measure of how much money management has to run the business.
Another measure of the money available to management is the capital of the business. This is its equity plus the long-term debt of the company.
Clearly the success of any business is going to depend on how well management uses its equity and its capital. This is commonly measured by two ratios called return on equity and return on capital. Putting it simply, these are defined as the earnings of the company divided by equity and by capital. Their abbreviations are ROE and ROC.
Many companies consistently lose money year after year. So they do not even have an ROE or ROC. Others have very low values for these ratios. In other words, management is struggling to make a profitable use of what it has. Clearly, these are not the sort of companies that we should think of as quality investments. If management is only making a few percent on the money that it has, then over time this is all you can expect to make if you purchase shares in the company. After all, money can’t come from nowhere.
Every year, Warren Buffett writes in the annual report of Berkshire Hathaway that he is eager to hear about businesses that, amongst other things, are earning “good returns on equity while employing little or no debt.” This means that ROE and ROC are essentially the same.
It makes sense. If you want a healthy return on any shares that you purchase, at the very least you need to select companies with management that is making a healthy return on the money that they have.
Secret #5: Stay away from “glitter” stocks
THERE ARE MANY thousands of stocks to choose from.Faced with these massive numbers and the associated deluge of information, investors get drawn to what I call glitter stocks. These are stocks that have some attention grabbing activity such as high trading volume, extreme movements in the price whether up or down, or when the stocks are in the news.
Even with the best of intentions, it is hard to look at these stocks in a clear and objective manner compared to the remaining stocks. Warren Buffett was so aware of this that he moved from New York back to his home town, Omaha, Nebraska. Regarding the benefits of living in Omaha, he said, “I think it’s a saner existence here. I used to feel, when I worked back in New York, that there were more stimuli just hitting me all the time… It may lead to crazy behavior after a while.” He ended by stating that it is much easier to think in Omaha.
A research study by Brad Barber and Terrence Odean of the University of California demonstrates very clearly the penalty to be paid by getting drawn into glitter stocks.
They found that, on average, individual investors tended to invest in glitter stocks more than professionals. Secondly, they found that by doing this they underperformed the market by anything from around 2.8 percent to 7.8 percent per annum.
Buffett has long understood this. For example, back in 1985 he said, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
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