How the Superinvestors did it

warrenbuffettstockfree
Warren Buffett

Time: May 17, 1984. Legendary investor Warren Buffett was making a speech at a seminar at Columbia Business School to celebrate the 50th Anniversary of the publication of Benjamin Graham and David Dodd’s Security Analysis.

A blurb in the article, The Superinvestors of Graham-and-Doddsville (By Warren E. Buffett), based on the speech by  Warren Buffett, said: “”Superinvestor” Warren E. Buffett, who got an A+ from Ben  Graham  in Columbia in 1951, never stopped making the grade. He made his fortunes using the principles of Graham’s and Dodd’s Security Analysis. Here, in celebration of that classic text, he tracks the records of investors who stick to the “value approach” and have gotten rich  going by the book.”

First some useful background:  Benjamin Graham (May 8, 1894 – September 21, 1976)  is the father of value investing, an investment approach that he began teaching at Columbia Business School in 1928 (Wikipedia). The British-born American professional investor was well-known for his book Security Analysis which was published in 1934. Together with co-author David Dodd, he refined his investment approach through various editions of the book. Since its publication, the book has been widely treated as an investment bible in the investment community. Benjamin Graham’s  best known disciple is Warren Buffett of Berkshire Hathaway. Warren Buffett, who himself is widely referred to the Wizard of Omaha, once  described Benjamin Graham as the second most influential person in his life after his own father. Warren Buffett once said  that Security Analysis was  an investment road map that he had been following.  Another of Benjamin Graham’s famous books is Intelligent Investor, described by Warren Buffett as “the best book about investing ever written”.

In The Superinvestors of Graham-and-Doddsville, Warren Buffett started by posing this question: “Is the Graham and Dodd “look for values with a significant margin of safety relative to prices” approach to security analysis out of date?”

Warren Buffett used the performance track record of a group of investors who had year in and year out beaten the Standard & Poor’s 500 stock index to counter theorists’ belief that it was all due to luck and that there were no undervalued stocks because of the stock market efficiency . Mr Buffett also used an imagined national coin-flipping contest to make his point.

The group of Superinvestors in the Graham-and-Doddsville presented by Warren Buffett included himself, his Berkshire Hathaway partner Charlie Munger and Walter Schloss,  Tom Knapp and Bill Ruane. Warren Buffett, Walter Schloss, Tom Knapp and Bill Ruane were the group of four who worked at Graham-Newmann from 1954 through 1956.

This group of successful investors had one common intellectual patriarch, Benjamin Graham, said Warren Buffett. They had gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by random chance.

“The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market,” said Warren Buffett.

“Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc. Incidentally, when businessmen buy businesses, which is just what our Graham & Dodd investors are doing through the purchase of marketable stocks –  I doubt that many are cranking into their purchase decision the day of the week or the month in which the transaction is going to occur,” said Mr Buffett. “If it doesn’t make any difference whether all of a business is being bought on a Monday or a Friday, I am baffled why academicians invest extensive time and effort to see whether it makes a difference when buying small pieces of those same businesses. Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.”

Mr Buffett said that he selected these men based upon their framework for investment decision-making. “I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament. It’s very important to understand that this group has assumed far less risk than average..”

While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.”

Elsewhere in the text, Warren Buffett said: “I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

Warren Buffett also explained the need of having a margin of safety. “You also have to have the knowledge to enable you to make a very general estimate about the value of the underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing. ”

In his conclusion about the value approach to investment, Mr Buffett said: “I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it…. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”

Fast forward to the present. Reflecting the great success of Warren Buffett’s value investment philosophy, Berkshire Hathaway’s 2013 Annual Report showed that “over the last 49 years (that is, since present management took over), book value has grown from US$19 to US$134,973, a rate of 19.7% compounded annually”. These are per-share book values.


Charlie Munger’s “lollapalooza effect” concept

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Lollapalooza 2015

In stock markets, we hear of this term called “lollapalooza effect”. In mid-2014, for example, when the stock of Apple plummeted at one stage by  40 per cent from a high of $700 to just below  $400, the cause was attributed in some quarters to the “lollapalooza effect”.

In a June 2014  article , “Apple Stock Still Suffering From The ‘Lollapalooza Effect'”,  the unusual circumstances surrounding Apple were described as follows: the death of Steve Jobs, the rapid decline of BlackBerry, and the rapid advance of Android OS and handset maker Samsung in particular. These unusual circumstances have been woven together into a popular narrative …This narrative sparked a mob mentality and drove Apple’s share price from its high of $700 down to just below $400 (a decline of over 40%).”

So the “lollapalooza effect” was the weaving together of the unusual circumstances to cause a stampede on the stock price of Apple.

The term “lollapalooza  effect” was propounded by Charles Munger,  the partner of legendary investor Warren Buffett at Berkshire Hathaway.

The word “lollapalooza” itself means  “a person or thing that is particularly impressive or attractive”; its origin is said to be in the late 19th Century.

But as an event,  lollapalooza   is an annual music festival featuring popular alternative rock, heavy metal, punk rock and hip hop bands, dance and comedy performances and craft booths. It has also provided a platform for non-profit and political groups and various visual artists. (Wikipedia)

Charlie Munger uses the term “lollapalooza effect” for multiple biases, tendencies or mental models acting at the same time in the same direction. With the lollapalooza effect, itself a mental model, the result is often extreme, due to the confluence of the mental models, biases or tendencies acting together. (Wikipedia)

This concept of lollapalooza effect,  which the intelligent investor needs to understand, was touched upon by Charlie Munger in a 1995 speech entitled Psychology of Human Misjudgement.  The latter was about his intriguing thoughts on the 25 tendencies that lead people  to make really bad decisions.  The ideas can be found in the  book “Poor Charlie’s  Almanack”, a collection of speeches and talks by Charlie Munger.

Mr Market a Drunken Psycho: Warren Buffett

Legendary investor Warren Buffett,  the Sage of Omaha, recently referred to Mr Market as the “Drunken Psycho”. Aspiring value investors need to know who Mr Market is to understand why Warren Bufftett calls him a Drunken Psycho. Warren Buffett has in a letter to Berkshire Hathaway also called Mr Market the poor fellow with incurable emotional problems. The term Mr Market was coined by Benjamin Graham,  the father of value investing and the author of the famous book , The Intelligent Investor, a book widely referred to  as the bible of value investing. 

Benjamin Graham used the term to personify the behavior of the stock market. Here is how Wikipedia put it: “Benjamin Graham’s favorite allegory is that of Mr. Market, an obliging fellow who turns up every day at the shareholder’s door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but sometimes it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or ignore him completely. Mr. Market doesn’t mind this, and will be back the following day to quote another price.

“The point of this anecdote is that the investor should not regard the whims of Mr. Market as a determining factor in the value of the shares the investor owns. He should profit from market folly rather than participate in it. The investor is advised to concentrate on the real life performance of his companies and receiving dividends, rather than be too concerned with Mr. Market’s often irrational behavior.”

Benjamin Graham, in his  parable about Mr Market, said: “Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Everyday he tells you what your interest is worth and further offers to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes to you seems to you a little short of silly.

“If you are a prudent investor or a sensible businessman will you let Mr. Market’s daily communications determine your view of the value of $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out  to him when he quotes you a ridiculously high price, and equally happy to sell to him when his price is low. But the rest of the time you will be wiser to form your own idea of the value of your holdings, based on full reports from the company about its operations and financial position.”

Benjamin Graham’s bottom line on Mr Market:  “Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he would be better off if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

In his letter (dated February 29, 1988 for FY1987) to Berkshire Hathaway shareholders, Warren Buffett, the most famous disciple of Benjamin Graham,  called Mr Market “the poor fellow with incurable emotional problems”.

Warren Buffet went on to say: “Ben’s Mr. Market allegory may seem out-of-date in today’s investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising “Take two aspirins”?

“…In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben’s Mr. Market concept firmly in mind.”

Recommended reading:

(1) The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013

Walter Schloss stock market secrets

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“Factors to make money in the stock market”

In a note dated March 10, 1994, Walter Schloss, a famous value investor named by Warren Buffett in 1984 as one of the superinvestors, listed 16 “Factors Needed To Make Money In The Stock Market”.

Walter Schloss (August 28, 1916 – February 19, 2012)  was a notable American value investor who was one of the famous disciples of Benjamin Graham. Benjamin Graham was of course  the founding father of value investor and the author of two famous books, The Intelligent Investor and Security Analysis.   Warren Buffett, the legendary investor known as the Sage of Omaha and the Oracle of Omaha,  is of course also a disciple of Benjamin Graham.

The following are the stock market secrets of Walter Schloss as listed in his note dated March 10, 1994.

“Factors needed to make money in the stock market”

1. Price is the most important factor to use in relation to value.

2. Try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper.

3. Use book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity. (Capital and surplus for the common stock).

4. Have patience. Stocks don’t go up immediately.

5. Don’t buy on tips or for a quick move. Let the professionals do that, if they can. Don’t sell on bad news.

6. Don’t be afraid to be a loner but be sure that you are correct in your judgment. You can’t be 100% certain but try to look for the weaknesses in your thinking. Buy on a scale down and sell on a scale up.

7. Have the courage of your convictions once you have made a decision.

8. Have a philosophy of investment and try to follow it. The above is a way that I’ve found successful.

9. Don’t be in too much of a hurry to see. If the stock reaches a price that you think is a fair one, then you can sell but often because a stock goes up say 50%, people say sell it and button up your profit. Before selling try to reevaluate the company again and see where the stock sells in relation to its book value. Be aware of the level of the stock market. Are yields low and P-E rations high. If the stock market historically high. Are people very optimistic etc?

10. When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as (h)igh as 125 and then decline to 60 and you think it attractive. 3 years before the stock sold at 20 which shows that there is some vulnerability in it.

11. Try to buy assets at a discount than to buy earnings. Earning can change dramatically in a short time. Usually assets change slowly. One has to know much more about a company if one buys earnings.

12. Listen to suggestions from people you respect. This doesn’t mean you have to accept them. Remember it’s your money and generally it is harder to keep money than to make it. Once you lose a lot of money, it is hard to make it back.

13. Try not to let your emotions affect your judgment. Fear and greed are probably the worst emotions to have in connection with purchase and sale of stocks.

14. Remember the work (of) compounding.  For example,  if you can make 12% a year and reinvest the money back, you will double your money in 6 yrs, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.

15. Prefer stock over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.

16. Be careful of leverage. It can go against you.

Recommended reading:

(1) The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)

(2) Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions)

Who’s Walter Schloss?

American investor Walter Schloss (August 28, 1916 – February 19, 2012) was another famous disciple of the Benjamin Graham school of investing. The noted value investor died in 2012 of leukemia.

Walter Schloss  was another great example that disproved the notion that the market was efficient. Talking of market efficiency, here’s a notable quote from legendary investor Warren Buffett in one of his letters to Berkshire Hathaway: “To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these.”

In  Walter Schloss’s case, he did not even attend college.

Here’s an excerpt from a Wikipedia account of him: “Schloss did not attend college. In 1934 at the age of 18, he started work as a runner on Wall Street. Schloss took investment courses taught by Graham at the New York Stock Exchange Institute. One of his classmates was Gus Levy, the future chairman of Goldman Sachs. He eventually went to work for Graham in the Graham-Newman Partnership.

“In 1955, Schloss left Graham’s company and started his own investment firm, eventually managing money for 92 investors. By maintaining a manageable asset size, Schloss averaged a 15.3% compound return over the course of four and a half decades, versus 10% for the S&P 500.”

Walter-Schloss

Walter Schloss won the 2012 Irving Kahn Lifetime Achievement Award from the  New York Society of Security Analysts. Part of the citation said: “In his 2006 Letter to Shareholders, (Warren) Buffett said, “Let me end this section by telling you about one of the good guys of Wall Street, my long-time friend Walter Schloss, who last year turned 90. From 1956 to 2002, Walter managed a remarkably successful investment partnership, which he did not take a dime from unless his investors made money. My admiration for Walter,  it should be noted, is not based on hindsight. A full 50 years ago, Walter was my sole recommendation to a St. Louis family who wanted an honest and able investment manager.”

In 1984, Warren Buffett named Walter Schloss as one of The Superinvestors of Graham-and-Doddsville.  The naming  was  in celebration of the fiftieth anniversary of the classic text, Security Analysis, by  Graham and Dodd.

Here’s what the Columbia Businees School said in reference to The Superinvestors of Graham-and-Doddsville by Warren Buffett: “Superinvestor” Warren E. Buffet, who got an A+ from Ben Graham at Columbia in 1951, never stopped making the grade. He made his fortune using the principles of Graham and Dodd’s Security Analysis. Here, in celebration of the fiftieth anniversary of that classic text, he tracks the records of investors who stick to the “value approach” and have gotten rich going by the book.”

Back to Walter Schloss. Here’s what Warren Buffett said of him in 1984 in The Superinvestors of Graham-and-Doddsville: “Walter has diversified enormously, owning well over 100 stocks currently. He knows how to identify securities that sell at considerably less than their value to a private owner. And that’s all he does. He doesn’t worry about whether it it’s January, he doesn’t worry about whether it’s Monday, he doesn’t worry about whether it’s an election year. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. He owns many more stocks than I do — and is far less interested in the underlying nature of the business; I don’t seem to have very much influence on Walter. That’s one of his strengths; no one has much influence on him.”

The underlying investment approach of Walter Schloss and Warrent Buffett is value  investing. Where they differed was  perhaps in the number of stocks owned and in the thinking on the underlying nature of a business.  Warren Buffett said Walter Schloss “was far less interested in the underlying nature of the business”.

Warren Buffett said in his letter (dated Feb 28, 1997 for FY1996) to Berkshire Hathaway shareholder: “Should you choose…to construct your own portfolio, there are a few thoughts worth remembering. “Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

Later in the letter, Warren Buffet said: “In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

Recommended reading:

(1) The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)

(2) Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions)

Economic moats checklist

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“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.” – Warren Buffett

“A moat is a deep, broad ditch, either dry or filled with water, that surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence.” – Wikipedia.

Legendary investor Warren Buffett coined the  term “moat” in finance.  A company needs a moat to protect its profitability and to fence itself against competitors.

If you’re an investor looking for the stock of a company that has an economic moat, remember that  Warren Buffett actually went one step further by saying  that the moat has to be one that is enduring.

“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital,”  Mr Buffett said in his letter to Berkshire shareholders (February 2008) for Year 2007.

“The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”

So what industries does Mr Buffet rule out then?

“Our criterion of ‘enduring’ causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s ‘creative destruction’ is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

“Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

“But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”

In Pat Dorsey’s book, The Five Rules For Successful Stock Investing, Pat Dorsey listed four steps to help analyze a company’s economic moat:

(1) Evaluate the firm’s historical profitability. The true litmus test of whether a firm has built an economic moat around itself is to see whether it has been able to generate a solid return on its assets and on shareholders’ equity.

(2) If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits. Ask questions like why the company is able to keep competitors at bay and what keeps competitors from stealing its profits.

(3) Estimate how long a firm will be able to hold off competitors, which is the company’s competitive advantage period. Some companies are able to fend off competitors for a few years while some are able to do it for decades.

(4) Analyze the industry’s competitive structure. Ask whether the firm is in an attractive industry with many profitable firms or a hypercompetitive one in which the players struggle just to stay afloat.

Recommended reading:

(1) Berkshire Hathaway Letters to Shareholders, 1965-2013

(2) The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market