Buffett and Beyond By Dr. J.B. Farwell This book is a work of non-fiction. Names and places have been changed to protect the privacy of all individuals. The events and situations are true. © 2004 by Dr. J.B. Farwell. All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted by any means, electronic, mechanical, photocopying, recording, or otherwise, without written permission from the author. ISBN: 1-4140-0050-2 (e-book) ISBN: 1-4140-0049-9 (Paperback) ISBN: 1-4140-0048-0 (Dust Jacket) Library of Congress Control Number: 2003095999 This book is printed on acid free paper. Printed in the United States of America Bloomington, IN 1stBooks - rev. 01/31/04 ACKNOWLEDGMENTS This book is dedicated first and foremost to Tom Barnes, Chief Engineer of the S.S. Yellowstone in 1978. Without him, I would not be here to write this book. To those of you who insisted that I write this book and especially to Debby who was there through the many long years of research, the writing of that dang Doctoral Dissertation and then the writing and re-writing and re-re-writing of this manuscript. To my wonderful family who always stood behind me. Always. I love you dad. And of course to Warren Buffett, the greatest investor of all time. After all is said and done, we all want to be as successful as Warren. iii iv TABLE OF CONTENTS INTRODUCTION The Timeliness of this Book................................ ix FOREWORD A Sea Story.................................................................. xi Luck: When Opportunity Meets Preparation CHAPTER 1 The Purpose of This Book............................................. 1 CHAPTER 2 About Warren Buffett.................................................... 5 CHAPTER 3 Determining the Earning Capacity of a Company ...... 11 (Now really, can it be this easy?) CHAPTER 4 My Theory of Why Most Money Managers of the World Cannot Outperform the Market Averages .............................. 27 CHAPTER 5 A Very Simple Income Statement and an Even Simpler Balance Sheet..................................................................................... 35 CHAPTER 6 The Return On Equity Ratio........................................ 41 What is the Difference Between the Accounting Return On Equity We Hear About Every Day and Clean Surplus Accounting Return On Equity? Answer: EVERYTHING! CHAPTER 7 The Return Portion of the Return on Equity Ratio...... 47 CHAPTER 8 The Equity Portion of the Return On Equity Ratio ..... 53 ADDENDUM TO CHAPTER 8 The General Motors Story ............ 65 v CHAPTER 9 How to Determine an Equitable Equity Number......... 67 CHAPTER 10 A Very Short Chapter on the Predictability of the Finance Valuation Models ................................................................. 73 CHAPTER 11 Clean Surplus ROE: The Only Comparable Efficiency Ratio................................................................................................... 81 Developing the Tools to Determine the Probability of Predictability CHAPTER 12 What Buffett Looks for in a Company ...................... 91 How Clean Surplus Accounting Recognizes the Quality of a Company CHAPTER 13 Buy Low and Sell High ............................................. 99 How Buffett Uses Clean Surplus Accounting to Determine the Future Target Price and the All-Important Purchase Price The Purchase Price CHAPTER 14 Beyond Buffett: The Dow Jones 30 Industrials....... 119 The Predictability of Clean Surplus Accounting Relative to the Dow 30 CHAPTER 15 Beyond Buffett: The S&P 500................................. 133 The Predictability of Clean Surplus Accounting Relative to the S&P 500 CHAPTER 16 Top Dogs of the Dow .............................................. 145 CHAPTER 17 What Have You Learned? A Summary................... 191 CHAPTER 18 We Won’t Leave You Out There Alone.................. 201 BuffettandBeyond.com vi DISCLAIMER ___________________________________________ There is no guarantee that while the method of stock investment described in this book has been effective in the past it will be so in the future. This publication contains the opinions and ideas of its author. It is not a recommendation to purchase or sell any of the securities discussed in this book. Both the author and publisher are not engaged in rendering legal, accounting, investment, financial or other investment services. Thus, neither the publisher nor the author will assume liability for any losses that may be sustained by use of the methods described in this book. Any such liability is hereby expressly disclaimed. vii viii INTRODUCTION ___________________________________________ The Timeliness of this Book By the late 1990s, stock ownership had become commonplace. In 1985, only 17% of all U.S. households owned stock. In 1995, 43% of households owned stock and by 2002, 63% of all the households in America participated in stock ownership. The number of financial advisers grew from 33,000 to 110,000. Insurance companies recommended investments. Banks sold mutual funds and stock brokers sold annuities, mortgages and yes, even stocks. The stock market roared and soared. Everyone seemed to be an expert on the market. Almost everyone had tips on stocks that would gain 100% over the following six months. The internet allowed access to anyone who wanted free research on company data. People quit their jobs to become day traders. Through all of this “irrational exuberance” little was heard from Warren Buffett. Buffett said he really didn’t understand what was going on in the technology field and so, no high-flying technology stocks graced his Berkshire Hathaway portfolio. During the latter part of the 1990s, most people began thinking of him as a relic of the past and very few sought his opinion on the market. In fact, many of the new brokers and new investment advisers had never heard of him. Also during the late 1990s, fundamental analysis was not considered important by many investors because everything went up in price. Then one day the bubble blew. Enron happened and stock analysts were exposed to criticism because of their conflicts of interest. Advisers began scratching their heads. The major questions for the beginning of the 21st century was what happened to the stock market and much more importantly, what do we do now? As the dust cleared, Warren Buffett was sought after for investment advice once again. Buying growth stocks at a good value ix was coming back into style. The problem was that very few people really understood how Warren Buffett selected his stocks. And even fewer investors had any clue whatsoever of the method he used in the determination of his all-important purchase price. Now that the investing world has regained some semblance of sanity, you’ll find out why the timeliness of this book will be so very important to your financial future. This book will show you the little- known stock selection methods of Warren Buffett. In addition, this book will also show you the very new and up-to-date research of the author which in turn, will take you one very, very important step BEYOND. By D. Everett President of Clean Surplus Investing, Inc. x FOREWORD ___________________________________________ A Sea Story Luck: When Opportunity Meets Preparation A sea story is a tale or a yarn. Something like one of those “fish that got away” stories. However, our tale actually does begin with a story about the sea. This foreword is a short story in itself. It is the story of how I came into contact with a little-known type of analysis, which was developed for the sole purpose of determining the predictability (or not) of the future performance of a company. Predictability of future performance is the Holy Grail of investing. After all, if we can predict reasonably well, we would be able to determine which stocks should grace our portfolio in order to outperform the market averages on a consistent basis. This method of predictability, of which I speak, eventually became known as Clean Surplus Accounting or Clean Surplus analysis. If the word accounting is intimidating to you, just substitute it with the word analysis because it really is a method of analyzing predictability. Up until this book, Clean Surplus Accounting had pretty much been lost since its possible beginnings in 1895, except for a few rare instances between then and now. The field of accounting just did not evolve in the direction of being able to provide much-needed predictability. It very well could have, but it didn’t. Clean Surplus was designed to try to provide that predictability. Very few people are presently aware of how to apply a reliable method of predictability to the fundamental elements of a stock. Very few people except for a small group of academics, a handful of practitioners and our friend, Warren E. Buffett. More on this later, but for now let’s discuss the xi events which guided me to my discovery of this wonderful method in the first place. It was luck, of course. But the definition of luck is when opportunity meets preparation. Had I not been involved in researching Clean Surplus Accounting and also at the exact same time reading everything about Warren Buffett that I could find, I never would have figured it out. On with our sea story and the events which guided my discovery. I began my post-graduate education very late in life. I began a Master’s program in Business and Finance at the ripe old age of 48 or so. In my prior life, I had been a Marine Engineer and over the course of 13 years I worked on ships sailing to far away places with strange- sounding names. During that time, I rose to the position of Chief Engineer. I was working on a ship carrying grain from the United States to the then Soviet Union and our ship had just entered the Mediterranean Sea through the Straits of Gibraltar. My position on that ship was a First Engineer, which is the position directly under the Chief Engineer. I brought most of the engine crew up on deck to see the great Rock of Gibraltar, but it was not to be, as we were sailing directly into a huge fog bank.