Wednesday, November 23, 2011

Buffett and You

Though he studied under Ben Graham and has adopted many of Graham's investing principles, the world's greatest investor is not your typical value investor. He speaks of margins of safety and of buying companies at discounts, but over the years Buffett has shown a willingness to buy businesses for what appears to be full price, at least on a P/E basis. What allows Buffett to do this and still generate excellent returns is his ability to understand economic "moats" better than anyone else.

For example, making headlines two years ago was Buffett's purchase of BNSF (BNI), a railway freight business. While most value investors are using this recession as an opportunity to gobble up companies trading for low P/E and P/B values, Buffett goes out and buys a company for a P/E of 16 (using peak 2008 earnings as the denominator!) and a P/B of 3. Ben Graham himself stated that purchasing companies with P/E ratios above 16 amounts to speculation, so what does Buffett do but make it his largest acquisition to date!

But flirting with high P/E's is nothing new for the Oracle of Omaha, as he has done so on several occasions. What all the high P/E acquisitions have in common, however, is a moat that allows each business to earn superior profits. For example, consider the return on equity (ROE) of BNSF over the last few years:

With the large size of Buffett's portfolio, his investment universe is fairly limited. While most of us have the benefit of being able to turn over every last rock to look for cheap companies, Buffett is limited to selecting from ocean-sized boulders. It is for this reason that BNSF offers an attractive investment opportunity for Buffett. With the ROE depicted above, Buffett will be able to allocate capital to this company (earnings from other businesses, insurance float etc.) and earn returns between 15% and 20%.

If it were this easy though, couldn't all large investors and insurers follow this formula? The advantage Buffett has over everybody else, however, is his superior ability to understand competitive advantages (or "moats"): he believes/knows that the ROE depicted above will continue for the foreseeable future. While he will be second-guessed (always has been, and always will be), his ability to predict moats has proven to be second to none.

Individual investors can certainly learn from Buffett, but are cautioned to avoid investing like him unless they know what they are doing. While Buffett likely benefits from having more information, more knowledge and a higher understanding of business than most investors, his major disadvantage is that his investing universe is so limited. Individuals are thus better off finding value in the analyst-ignored small cap universe where stock prices are the most inefficient and where companies trading at large discounts can be found.


mmel said...

Very well said. I don't think enough individual investors realize the advantages they have when it comes to their own funds. Too many people criticize Buffett for getting choice deals and inside info, when really they are just being lazy and should recognize that he would likely prefer working with smaller sizes. And besides, for anyone who doesn't want to do the work and take advantage of their expanded universe, just buy BRK when its close to book and earn his returns.

Anonymous said...

It would be interesting to see Buffet in action if he had only a million to invest.

Stable Investor said...

It is tough and wrong to imitate Warren Buffet. He knows what he is doing and as he has rightly put,
Risk comes from not knowing what you are doing would be better if investors stick with stocks which they understand

Ankit Gupta said...

I don't think low P/E's define value investing - you can find value in anything, even at very high P/E's. Growth investing can be done using the same value principles.

Value investing simply means buying from a discount to the intrinsic value. If a growth company is growing a lot and trades at a 30x P/E multiple, but you believe it's worth 60x earnings, then you could buy it and have it be a value investment.

My issue with stock screeners is that there's too much that can be missed out on when doing quantitative measures - I find too many scenarios where it's actually misleading to buy solely off of the P/E ratio.