Fin 4201/8001 Topic 2: The Three Wise Men

WB – Philosophy Investment selection Investment selection “The best way to hit a home run: Don’t swing at everything; wait for a fat pitch.” “The best way to hit a home run: Don’t swing at everything; wait for a fat pitch.” “You find these well-smoked, down-to-the- nub cigars, but they’re free. You pick them up and get one free puff out of them. Anything is a buy at a price.” “You find these well-smoked, down-to-the- nub cigars, but they’re free. You pick them up and get one free puff out of them. Anything is a buy at a price.” Portfolio management Portfolio management “The best way to outperform the market: Don’t load up on hundreds of stocks; “The best way to outperform the market: Don’t load up on hundreds of stocks;

WB – Philosophy On Ben Graham On Ben Graham “(Graham) wasn’t about brilliant investments and he wasn’t about fads or fashion. He was about sound investing, and I think sound investing can make you very wealthy if you’re not in too big of a hurry. And it never makes you poor, which is better.” “(Graham) wasn’t about brilliant investments and he wasn’t about fads or fashion. He was about sound investing, and I think sound investing can make you very wealthy if you’re not in too big of a hurry. And it never makes you poor, which is better.” “Next to my dad, Ben Graham had more impact certainly on my business life than any other individual.” “Next to my dad, Ben Graham had more impact certainly on my business life than any other individual.” Portfolio management Portfolio management “The best way to outperform the market: Don’t load up on hundreds of stocks; “The best way to outperform the market: Don’t load up on hundreds of stocks;

The Three Wise Men “I’m 15% Philip Fisher and 85% Benjamin Graham” “I’m 15% Philip Fisher and 85% Benjamin Graham” Benjamin Graham Benjamin Graham Philip Fisher Philip Fisher Charles Munger Charles Munger

Ben Graham (1894 – 1976) Dean of financial analysis. Dean of financial analysis. “before him there was no (financial analysis) profession and after him they began to call it that.” --Adam Smith (1972) “before him there was no (financial analysis) profession and after him they began to call it that.” --Adam Smith (1972) Most famous for: Most famous for: Security Analysis, coauthored with David Dodd and published in 1934 Security Analysis, coauthored with David Dodd and published in 1934 The Intelligent Investor, published in 1949 The Intelligent Investor, published in 1949

Ben Graham (1894 – 1976) Columbia University Bachelor of Science Columbia University Bachelor of Science Messenger in Wall Street brokerage firm Messenger in Wall Street brokerage firm By 1919 (age of 25) was a partner and earning $600,000/year By 1919 (age of 25) was a partner and earning $600,000/year In 1926, formed own partnership – Graham Newman In 1926, formed own partnership – Graham Newman Dissolved the partnership and retired in 1956 Dissolved the partnership and retired in 1956

Ben Graham (1894 – 1976) While at Graham-Newman taught night courses in finance at Columbia University While at Graham-Newman taught night courses in finance at Columbia University Two most important contributions to Buffettoloby Two most important contributions to Buffettoloby Investment vs. Speculation Investment vs. Speculation A systematic (Quantitative) approach to investment with the concept of Margin of Safety. A systematic (Quantitative) approach to investment with the concept of Margin of Safety.

Investment vs. Speculation “An investment operation is one which, upon thorough analysis, promises safety of principal and satisfactory return. Operations not meeting these requirements are speculative.” “An investment operation is one which, upon thorough analysis, promises safety of principal and satisfactory return. Operations not meeting these requirements are speculative.” Investment in bonds can also be speculative. What is important is a quantitative approach to investment Investment in bonds can also be speculative. What is important is a quantitative approach to investment

Three reasons for the Crash of 1929 Manipulation of stocks by the exchanges and investment firms Manipulation of stocks by the exchanges and investment firms Practice by banks of lending money for the purpose for buying stocks Practice by banks of lending money for the purpose for buying stocks Uncontrolled optimism that was driving it all Uncontrolled optimism that was driving it all The first two have been solved to a large extent The first two have been solved to a large extent

Three approaches to investment Cross-section approach Cross-section approach Equivalent to today’s indexing or passive investing Equivalent to today’s indexing or passive investing Anticipation approach Anticipation approach Short-term selectivity – Invest in near term favorable Short-term selectivity – Invest in near term favorable Growth stock – Invest in companies with earnings growth > average Growth stock – Invest in companies with earnings growth > average Margin of Safety approach Margin of Safety approach

Margin of Safety Approach After deciding what to buy (later), investor has to decide when to buy After deciding what to buy (later), investor has to decide when to buy Buy when everything is selling cheap (bear) Buy when everything is selling cheap (bear) Buy when the particular stock is trading below its intrinsic value, irrespective of the market condition Buy when the particular stock is trading below its intrinsic value, irrespective of the market condition Graham believed the first approach is futile. Graham believed the first approach is futile.

Margin of Safety Approach For bonds, margin = Earnings – fixed charges For bonds, margin = Earnings – fixed charges Stocks, “When a stock is priced well below its intrinsic value, a margin of safety automatically exists.” Stocks, “When a stock is priced well below its intrinsic value, a margin of safety automatically exists.” Intrinsic value? Intrinsic value? “that value which is determined by facts” “that value which is determined by facts” Earning potential Earning potential Qualitative factors Qualitative factors

Art and science of financial analysis Quant = Balance sheet, Income Statement, Cash flows,… Quant = Balance sheet, Income Statement, Cash flows,… Company assets, earnings and dividends, and any future DEFINITE prospects Company assets, earnings and dividends, and any future DEFINITE prospects Qualitative – not easy, but essential to intrinsic value Qualitative – not easy, but essential to intrinsic value Management capability Management capability Nature of business Nature of business

Margin of Safety Graham believed that there is little margin of safety if the qualitative factors make a major part of the intrinsic value. Graham believed that there is little margin of safety if the qualitative factors make a major part of the intrinsic value. Buy a company for less than two-thirds of its net asset value (NAV) Buy a company for less than two-thirds of its net asset value (NAV) No weight to PPE No weight to PPE Deduct all short/longterm liabilities Deduct all short/longterm liabilities focus on stocks with low price-to-earnings (P/E) ratio focus on stocks with low price-to-earnings (P/E) ratio Wrong market price & mean reversion Wrong market price & mean reversion

Philip Fisher Graduated from Standford’s Graduate School of Business Graduated from Standford’s Graduate School of Business Analyst at Anglo-London-Paris Bank in San Francisco Analyst at Anglo-London-Paris Bank in San Francisco After two years head of Bank’s Statistical Department After two years head of Bank’s Statistical Department Started advisory firm, Fisher & Company in 1931 Started advisory firm, Fisher & Company in 1931

Philip Fisher Superior profit in firms with above average potential with the most capable management. Superior profit in firms with above average potential with the most capable management. Point system to identify good companies Point system to identify good companies “Investment success depends on finding companies that can sustain above-average growth, in both sales and profits, over a period of several years. Short-term results are deceptive.” “Investment success depends on finding companies that can sustain above-average growth, in both sales and profits, over a period of several years. Short-term results are deceptive.”

Philip Fisher Fortunate and able Fortunate and able Aluminum Company of America Aluminum Company of America Fortunate because able Fortunate because able Dupont Dupont “Investment success depends on finding companies that can sustain above-average growth, in both sales and profits, over a period of several years. Short-term results are deceptive.” “Investment success depends on finding companies that can sustain above-average growth, in both sales and profits, over a period of several years. Short-term results are deceptive.”

Essential Qualities 1) R&D expense 2) Strong Marketing 3) Low break even; lowest-cost producers 4) Ability to grow without new equity 5) Superior management

“Superior management is the key to superior market performance.” 1) Long term target of consistent performance? 2) Management of unquestionable integrity and honesty? 3) Do managers communicate with shareholders? 4) Relationship between management and employees? 5) Management characteristics vs. peers

Scuttlebutt approach Find out what kind of reputation the firm has Find out what kind of reputation the firm has Cross-sectional view of the firm Cross-sectional view of the firm Customers, vendors, former employees, competitors, trade associations… Customers, vendors, former employees, competitors, trade associations… Since time consuming, Fisher’s portfolio was focused on a few stocks. ≈ Buffett’s “Circle of Competence” Since time consuming, Fisher’s portfolio was focused on a few stocks. ≈ Buffett’s “Circle of Competence”

Charles Munger “Charlie-and-I” “Charlie-and-I” Functionally investment co-manager Functionally investment co-manager Son of lawyer and grandson of Federal judge Son of lawyer and grandson of Federal judge Harvard Law School - Practiced law in LA; Joined BRK in 1978 Harvard Law School - Practiced law in LA; Joined BRK in 1978 “Look for companies that generate high cash earnings and require low capital expenditure.” “Look for companies that generate high cash earnings and require low capital expenditure.” “It is far better to pay a fair price for a great company than a great price for a fair company.” “It is far better to pay a fair price for a great company than a great price for a fair company.”

See’s Candy 1972 Turning point in the investment philosophy of Berkshire Hathaway Turning point in the investment philosophy of Berkshire Hathaway Charlie convinced Warren See’s was a good buy at three times the book value. Charlie convinced Warren See’s was a good buy at three times the book value. Not picking up as many cigar butts! Not picking up as many cigar butts!

Put it all together… it spells success Graham = buy cheap, margin of safety, ignore management and sector (Quant) Graham = buy cheap, margin of safety, ignore management and sector (Quant) Some of WB’s investments were cheap for a reason (original Berkshire Hathaway) Some of WB’s investments were cheap for a reason (original Berkshire Hathaway) View stocks as investments = long-term View stocks as investments = long-term Fisher = more business and management focused (Qual) Fisher = more business and management focused (Qual) Charlie = move WB from to Charlie = move WB from to 50-50