E1FFIRS Date: Jan 19, 2010 Time: 10:56 am E1FFIRS Date: Jan 19, 2010 Time: 10:56 am Buffett Beyond Value E1FFIRS Date: Jan 19, 2010 Time: 10:56 am E1FFIRS Date: Jan 19, 2010 Time: 10:56 am Buffett Beyond Value Why Warren Buffett Looks to Growth and Management When Investing Prem C. Jain John Wiley & Sons, Inc. E1FFIRS Date: Jan 19, 2010 Time: 10:56 am Copyright © 2010 by Prem C. Jain. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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HG4521.J264 2010 332.6–dc22 2009041474 Printed in the United States of America 10987654321 E1FTOC Date: Feb 4, 2010 Time: 2:24 pm Contents Preface ix Acknowledgments xv Part One Introduction and Background 1 Chapter 1 The Thrill of Investing in Common Stocks 3 Chapter 2 1965–2009: Lessons from Significant Events in Berkshire History 9 Part Two Buffett Investing = Value + Growth 23 Chapter 3 Value Investing—It’s Like Buying Christmas Cards in January 25 Chapter 4 Growth Investing 43 Chapter 5 Intrinsic Value 57 Chapter 6 Buffett Investing = Value + Growth 69 v E1FTOC Date: Feb 4, 2010 Time: 2:24 pm vi contents Part Three Other People’s Money 87 Chapter 7 Insurance: Other People’s Money 89 Chapter 8 Reinsurance: More of Other People’s Money 99 Chapter 9 Tax Deferment: Interest-Free Loans from the Government 109 Part Four Success in Retailing, Manufacturing, and Utilities 113 Chapter 10 If You Don’t Know Jewelry, Know Your Jeweler 115 Chapter 11 Compete Like Mrs. B 123 Chapter 12 Why Invest in Utility Companies? 129 Chapter 13 High Profits in Honest-to-Goodness Manufacturing Companies 137 Part Five Risk, Diversification, and When to Sell 143 Chapter 14 Risk and Volatility: How to Think Profitably about Them 145 Chapter 15 Why Hold Cash: Liquidity Brings Opportunities 155 Chapter 16 Diversification: How Many Baskets Should You Hold? 161 Chapter 17 When to Sell 169 Part Six Market Efficiency 175 Chapter 18 How Efficient Is the Stock Market? 177 Chapter 19 Arbitrage and Hedge Funds 185 E1FTOC Date: Feb 4, 2010 Time: 2:24 pm Contents vii Part Seven Profitability and Accounting 193 Chapter 20 M = Monopoly = Money 195 Chapter 21 Who Wins in Highly Competitive Industries? 205 Chapter 22 Property, Plant, and Equipment: Good or Bad? 211 Chapter 23 Key to Success: ROE and Other Ratios 217 Chapter 24 Accounting Goodwill: Is It Any Good? 223 Part Eight Psychology 229 Chapter 25 How Much Psychology Should You Know? 231 Chapter 26 How to Learn from Mistakes 243 Part Nine Corporate Governance 249 Chapter 27 Dividends: Do They Make Sense in This Day and Age? 251 Chapter 28 Should You Invest in Companies That Repurchase Their Own Shares? 257 Chapter 29 Corporate Governance: Employees, Directors, and CEOs 263 Chapter 30 Large Shareholders: They Are Your Friends 273 Conclusion B = Baseball = Buffett 277 Appendix A Summary of the Book 281 Notes 283 About the Author 295 Index 297 E1FTOC Date: Feb 4, 2010 Time: 2:24 pm E1FPREF Date: Jan 19, 2010 Time: 11:46 am Preface his book is for everyone with a serious interest in learning about stock market investing using principles espoused by Warren T Buffett. Just over 20 years ago, while teaching at the Wharton School, I stumbled upon an essay by Warren Buffett that motivated me to carefully investigate his investment style.1 I was intrigued when I real- ized that there was a fundamental difference between Buffett’s attitude toward investing and the academic approach. While academics generally anchor on the impossibility of making above-average returns, Buffett proposes just the opposite. He argues that with a careful study of company fundamentals and management quality, investors definitively can earn above-average returns. His outstanding long-term record supports his claim. When faced with Buffett’s record, most academics either dismiss it as an outlier or brand him a genius who cannot be copied or explained. I wanted to know if there was a systematic way of understanding and emulating his investment philosophy. Most authors, including academics, characterize Buffett as a value investor. Buffett is not just a value investor—at least not in the popular sense that the “value” moniker is used. Buffett’s publicly traded company, Berkshire Hathaway, has grown at an annualized rate of about 20 percent in assets, revenues, net worth, and market value for 44 years. His per- formance is closer to what would be expected from a successful growth investor. Unlike other businessmen who may have also amassed great for- tunes, Buffett stands alone because his long-term success reflects growth ix E1FPREF Date: Jan 19, 2010 Time: 11:46 am x preface of his business and investments in several different industries without ever riding a hot trend. There is another major difference between Buffett and other successful investors, which is actually the main reason I chose to study him diligently. Warren Buffett is a man of the highest level of integrity. He knows that he has a special gift, and instead of keeping it to himself, he has chosen to share his immensely valuable experiences with anyone who cares to do some research. A remarkable teacher, Buffett has written a considerable body of material on his ideas and principles, which allows for careful examination of his strategies and motivations. The key reason for Buffett’s unparalleled success is not only his ability to stay resolute with the primary value investing principle of maintain- ing a low downside risk but also his skill at pairing it with the growth investing principle of putting money into companies with sustainable growth opportunities. Thus, he combines the principles of both the value and growth investment strategies. Yet, he does not invest in high- tech companies, as so many growth investors do. His growth strategy is best understood by studying the businesses he has purchased at Berkshire Hathaway. Buffett buys good businesses that already possess outstand- ing, high-integrity management. He relies on the same principles for investing in common stocks. I elaborate on his investment principles throughout the book along with the specific topics covered in each chap- ter. These principles are useful whether you are investing in a bull market or a bear market. Buffett and Contemporary Teachings at Business Schools My goal as a teacher-researcher is not only to explore what Buffett practices but also to find answers to why his practices are successful. In 1997, my desire to understand why Buffett’s investment style works and how his strategies blend with the lessons from contemporary finance led me to develop a new course at Tulane University. This course took a new approach to finance, where students studied Buffett’s writings and decisions in conjunction with modern finance research. The students also analyzed a large number of businesses. In 1999, Tulane contributed $2 million from the university’s endowment fund to create a portfolio E1FPREF Date: Jan 19, 2010 Time: 11:46 am Preface xi to be managed by students under my guidance. I left Tulane in 2002 for Georgetown University, but Professor Sheri Tice continues to teach the increasingly popular course at Tulane. From the outset, it is important to recognize that Buffett’s ideas are not always at odds with modern finance theories. For example, the con- cepts of discounting cash flows and net present value are taught in all business schools.