Trader's Notes #2 : Warren Buffet and the Art of Compounding Forever

It is very hard to look at this famed investor without the hyperbole surrounding him. Sometimes it feels it’s nearly impossible to separate his persona from his actual investing lessons. The former is the one that is talked about more , the latter is where the real learning lies. It doesn’t matter if you live in a farm or space, whether you trade or invest, what matters in a purely market terms is if you are actually good at this Sport. And this is where this man shines. He is beyond the hyperboles, he is out to play strong, play hard and play forever.

The Birth of Berkshire Hathaway

Warren Buffett always ranks near the top of Forbes’s list of the richest people in the world, and virtually all of his net worth has been generated by investing. As the CEO of Berkshire Hathaway, his investment holding company, Unlike many hedge fund managers, Buffett doesn’t skim off a large percentage of the investment profits he generates.

Buffett had a nose for making money even as a young child growing up in Omaha. While still in elementary school, he sold packs of Wrigley’s gum and cans of Coca-Cola, both future investments for him. He bought his first stock at the age of 11 and filed his first tax return at the age of 13.

After finishing his undergraduate degree at the University of Nebraska, he applied to Harvard and was rejected. It turned out to be a blessing in disguise, because he was accepted at Columbia and studied under the man who would change his investing life, the pioneer of value investing Benjamin Graham.

When Graham decided to wind down his investment business, which Buffett had joined in 1954, Buffett set up his own investment business through a series of partnerships that were, in essence,hedge funds. In 1969, Buffett decided the stock market was overvalued and shut down the investment partnerships. He recommended 3 options to his partners at the time.

  1. Take the cash from the liquidated partnerships.

  2. Invest with his friend, the value investor Bill Ruane, of the Sequoia Fund.

  3. Take shares in a company he controlled—Berkshire Hathaway.

Buffett acquired Berkshire shares in 1962, when it was a struggling textile maker. The textile business never turned around, but Buffett used the cash flow to acquire other businesses. One of Berkshire’s investing hallmarks was insurance, which historically accounts for
the bulk of its profits.

An insurer has the use of every insurance premium for a period of time—from a day to months to forever—before it has to pay a claim on someone’s behalf. This time-value of money, called the “float,” is a boon to an investor like Buffett, who can put it to good use.

The Moat as a Competitive Advantage

Eventually, Buffett moved away from Graham’s strict approach.He continued buying companies at a discount, but his focus shifted to high-quality companies, especially those with a durable
competitive advantage—what Buffett called a moat—a buffer around a company’s core business that makes attack difficult for the competition.

Two popular approaches to analyzing a company’s moat are Porter’s 5 Forces and Morningstar’s Economic Moat Framework.

Michael Porter is a Harvard Business School economist who in the 1980s developed aframework to help explain the impact of industry structure on performance, generally referred to as Porter’s 5 Forces.

The threat of new entrants : Certain businesses require massive capital to get started. The Boeing and Airbus commercial-aircraft manufacturing business is a case in point.The harder it is for a new firm to enter a market, the greater the competitive advantage of the firms already in that market.

The threat of substitute products or services : Although some products have no substitute, most industries offer a variety of substitutes: Coke vs. Pepsi. The fewer substitute products or
services, the greater the competitive advantage.

The bargaining power of customers : The Internet has given customers great power. Best Buy went from being a dominant company to one struggling to survive because customers could search for better prices on Amazon and other websites.

The bargaining power of suppliers : The less a firm is impacted by its suppliers, the greater its competitive advantage. The De Beers cartel of South Africa controls about 35% of the
diamonds produced in the world. De Beers has extraordinary bargaining power when dealing with jewelry merchants.Conversely, clothes can be manufactured fairly cheaply in many places around the world, so companies like Nike have a lot of power in their supplier relationships.

The intensity of competitive rivalry : Firms in the airline industry, such as U.S. Airways, went bankrupt because of intense competition. Conversely, the less intense the rivalry, the greater the competitive advantage.

Morningstar, a firm known for its research on mutual funds, created a framework for its research rating based to a large extent on a company’s moat. Like Porter, Morningstar identified 5 factors.

1.The first factor is the network effect : Why do people shop at Amazon? Because millions of items are for sale. Why do people join Whatsapp? Because nearly all of their friends, family and colleagues are on it.Morningstar believes a network effect occurs when the value of a company’s service increases, as more people use the service.

  1. The second factor is intangible assets. A patent is an intangible asset that provides legal protection lasting up to 20 years. A brand name is an invaluable asset that can be hard
    to quantify, but easy to see in action.

  2. The third factor is cost advantage : The concept of a cost advantage can easily apply to many industries. For example, stories abound of Wal-Mart and Home Depot driving their smaller competitors out of business because they couldn’t match the larger firms’ low prices. Having a cost advantage also gives these companies the opportunity to raise prices without worrying about losing the bulk of their customers.

  3. The fourth factor is switching cost : Imagine if you had a new alarm system installed in your house. It would be expensive to switch it for a new system, even if the new system had lower
    monthly fees. The same concept applies to other products.

5.The fifth factor is efficient scale : Efficient scale relates to a niche market served by a small number of companies—in some cases, only one. For example, building a hospital is a
massive undertaking, so there is likely to be only one in each town or county.

Buffett came to believe that a better approach to value investing would be to buy high-quality companies with a moat around their businesses.

Boldness in a Crisis

The epicenter of the financial markets crisis was the housing industry and the subprime mortgages lent to people with poor credit ratings. Bank risk managers reasoned that if the borrower couldn’t pay the mortgage, they could simply take the house as collateral.

They believed the house would rise in value so they wouldn’t lose on a diversified portfolio of these loans. When consumers defaulted on their loans and real estate prices crashed, excessive leverage (debt-to-equity ratio) on the part of both consumers and banks led to financial disaster.

Purchasing a house with a 20% down payment results in leverage of 5 to 1; many banks were leveraged at a ratio of 30 to 1 or more.

The investment bank Bear Stearns was one of the first casualties of the housing and financial markets crisis. It was sold to JP Morgan for $2 a share. Lehman Brothers, an investment bank that had been around since 1860, declared the biggest bankruptcy ever.

In this financial environment in September 2008, Buffett had the confidence to invest in Goldman Sachs and General Electric Capital Corporation. Buffett invested $5 billion in Goldman and $3 billion in GE convertible preferred stock with a 10% dividend. By March 2011, Buffett earned $3.7 billion in realized and unrealized profit on Goldman Sachs. By September 2011, he made at least $1.2 billion from his GE investment.

Some Losing Investments

But even The Oracle can make blunders. Buffett often refers to Berkshire’s purchase of Dexter Shoe Company as one of his worst investments ever. In 1993, Berkshire paid $433 million for the Maine-based shoe company. Buffett’s biggest mistake wasn’t that Dexter’s shoe business deteriorated rapidly. It was that he paid for the deal in Berkshire stock, which has risen exponentially since the purchase. He has rarely used Berkshire stock in future acquisitions and had a successful investment in the dominant casual shoe company, Nike.

His investment in IBM was also criticized by some investors, who viewed IBM as a dinosaur in a technology world dominated by Google, Apple, Microsoft, Amazon, and the like. Buffett first started buying IBM in the first quarter of 2011. He invested more than $13 billion at a cost basis of $170 a share. Recently, IBM was trading at roughly $160 a share, resulting in a paper loss of more than $750 million.

In the end, the numbers speak for themselves. In the 50 years after Buffett took over Berkshire in 1965, the S&P 500 was up 11,355%. In contrast, over the same period, Berkshire’s stock was up an amazing 1,600,000%. (Ugh)

I am sure a lot of people here have a lot of thoughts on him. Please feel to share your views.


You write so well buddy. Please keep writing such insightful posts.

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