THE ESSAYS OF WARREN BUFFETT
Living quiet, unpretentious lives Mr. and Mrs. Othmer - a professor of
chemical engineering and a former teacher - died in their nineties.When the
Othmer's died, friends were shocked to learn that their estate wasworth $800
million. (See: members.aol.com
The Othmer story is not unique. Anne Scheiber never married and workedfor the
government, never making more than $4,000 a year. She lived a quiet,simple
life. When she died in 1995, her estate was worth $22 million.Likewise, Jacob
Leeder lived in a modest home and drove a 1984 Oldsmobile station wagon.
Occasionally he would go out to eat - usually at a cheap,cafeteria-style
restaurant. It wasn't until Leeder died last year that friendsdiscovered that
he was worth $36 million. (See: members.aol.com
How did these people get so rich? Like many long term investors, theyput
their money into well managed undervalued companies and left it there.(See:
globe.com
The Othmers had an additional benefit: in the early 1960s they eachinvested
$25,000 with Warren Buffett. Today Mrs. Othmer's shares are worth $578
million; her husband's, sold on his death when the price was lower,were worth
$210 million. Even without Mr. Buffett, if they had put their fundsinto the
broader market they still would have done well - having an estate with a
current value of between $50 million and $100 million.
The Essays of Warren Buffett
The investment strategies utilized by Warren Buffett to attain theOthmer's
gains were recently published by a law professor at Cardozo University.
Entitled "The Essays of Warren Buffett: Lessons for Corporate America"it is a
compilation of Buffett's annual reports and other communications, andis a
good overview for those not familiar with his investment philosophy(available
by sending $17.45 to Prof. Lawrence Cunningham, Cardozo University, 55Fifth
Ave., New York, NY 10003). Some of Buffett's more interesting investment
philosophies are as follows:1. Buy a Good "Business Boat"
Buffett points out the importance of choosing a company situated in agrowing
and profitable industry. He identifies his largest investment mistake -buying
the company his firm was named after (Berkshire Hathaway) - not becausethe
company was flawed, but because the industry it was in (textiles) was so
unattractive.
Buffett recalls how the textile industry provided very meager returnsfor
Berkshire. No matter how well managed the company was it would alwayshave
subnormal returns. The textile industry was a commodity business,competitors
had facilities located overseas that were low cost producers, andsubstantial
excess capacity existed worldwide.
Buffett claims he would not close down a business that is important to a
community just to improve the corporate rate of return, but if itappeared
that losses would be unending no other course of action makes rational
economic sense.
Buffett notes "a good managerial record (measured by economic returns)is far
more a function of what business boat you get into than it is of how
effectively you row . . . Should you find yourself in achronically-leaking
boat, energy devoted to changing vessels is likely to be moreproductive than
energy devoted to patching leaks."2. Compound Returns by Deferring Taxes
One reason that the Othmer's were able to accumulate $800 million inassets
was because their investment in Berkshire stock compounded and theircapital
gains taxes were never realized. "Tax-paying investors will realize afar, far
greater sum from a single investment that compounds internally at agiven rate
than from a succession of investments compounding at the same rate. ButI
suspect many Berkshire shareholders figured that out long ago"according to
Buffett.Illustrating the point he notes "imagine that Berkshire had only $1,
which weput in a security that doubled by year end and was then sold. Imagine
furtherthat we used the after-tax proceeds to repeat this process in each of
the next19 years, scoring a double each time. At the end of the 20 years . . .we
would be left with $25,250. Not bad. If, however, we made a singlefantastic
investment that itself doubled 20 times in 20 years . . . we would beleft
with about $692,000."
Buffett's calculations use a capital gains tax rate of 34% - muchhigher than
today's, but the point is well taken. Deferred taxes allow aninvestment to
compound, increasing the return on investment.3. Concentration of Investments
Professor Cunningham notes that "contrary to modern finance theory,Buffett's
investment knitting does not prescribe diversification. It may evencall for
concentration . . . a strategy of financial and mental concentration may
reduce risk by raising both the intensity of an investor's thinkingabout a
business and the comfort level he must have with its fundamental
characteristics before buying it."
Other articles have noted the tendency of Buffett to concentrate his
investments, and claim that this is part of his success. If nothingelse,
concentration allows an investor to follow a company much more closely- which
allows them to better judge when a stock is undervalued.
4. Good Business Judgment & Mr. Market
Buffett subscribes to the theory that the market is not alwaysefficient, and
that at certain times companies will be grossly undervalued orovervalued. The
market allows an astute investor to buy positions in companies wellbelow
intrinsic values. In the long term, such value will be recognized.
"An investor will succeed by coupling good business judgment with anability
to insulate his thoughts and behavior from the super-contagiousemotions that
swirl about the marketplace . . . The speed at which a business'ssuccess is
recognized is not that important as long as the company's intrinsicvalue is
increasing at a satisfactory rate - in fact, delayed recognition can bean
advantage: It may give us the chance to buy more of a good thing at abargain
price."5. Small Base From Which to Grow
Due to the size of the funds Berkshire now manages, Buffett recognizesthat
the return he will obtain from his investments will be lower than whenhe was
managing much smaller sums. Using analogies to the growth of bacteria,he
notes that growth from a small base can continue at a much faster pacefor
much longer than from a large base.
The larger sums now being managed limit the size of companies Berkshirecan
invest in - using a concentrated investment approach meaningfulinvestments in
small and micro-cap companies cannot be made. Summary
Those who are familiar with Buffett's investing style, or who have readsome
of the books on him published recently or the Berkshire annual reports,will
find little new here. Even so, it is always interesting to read thethoughts
and investment strategies of one of the world's most successfulinvestors.
*******************IS THE MARKET A CASINO?
James Glassman recently had an article in the Washington Post pointingout
that the longer an investment is held, the lower the risk of a loss inthe
market. (See: members.aol.com
"The stock market has been compared to a casino" he notes, "when infact, it
is the opposite. At a casino, the house rakes off its profit, so, in arandom
game, if you play long enough, you are nearly certain to lose. Bycontrast,
the market, on average, produces positive returns. In a random game with
stocks, you are certain to win -- unless you get fidgety and move inand out
of shares, letting your own bad sense and recurrent transaction costseat up
your dough." Glassman continues with the following statistics to support his
argument;"Large-cap stocks have produced profits in 52 of the past 72 years. In
otherwords, the odds are three to one in favor of any year scoring a positive
return. Over five-year periods, stocks have been profitable 61 timesout of
68, making your odds nine-to-one in favor of a positive return. Over15-year
periods, stocks have been profitable 58 times out of 58, which iscalled a
sure thing." While the economy as well as the market fluctuates periodically,
sometimesdramatically, Glassman notes that Ibbotson Associates Inc. found that
"overthe 70 years ending in 1995, an investment of $1 in the S&P 500 index,
a goodproxy for the market, grew to $1,114. But for an investor who missed
the best35 months during that 840-month period, $1 grew only to $10. In other
words,99% of the gains occurred during just 4% of the time."
"How can you be sure of being in the market during that golden 4%period? By
being in the market during the leaden 96%. That's the only way."
"The lesson from all this is that the best way to approach the market is
simply to go along for the ride, wherever it leads. Eventually, even ifthe
route is roundabout, you will reach your destination -- an averagereturn on
your money of 10% or more a year."************** ****
POLITICAL SPEED BUMPS AHEAD?
The Federal Reserve's report to Congress last week on monetary policyand the
economy noted that the "booming U.S. stock market continued to attractlarge
foreign interest." The Asian crisis has been a large factor as investors
placed their money in what is perceived as a safe place - the U.S.
Private foreign investors bought a blistering $29 billion more in U.S.stocks
than they sold in the first quarter of the year - a record annualizedrate of
$116 billion. That followed record net purchases of $66 billion in1997. Much
of the foreign money has been flowing into larger capitalizationstocks. (See:
washingtonpost.com
Economic Growth Continues
Meanwhile the Commerce Department reported that the U.S. economy grewat a
rate of 1.4% in the last quarter, down from the 5.5% expansion in thefirst
quarter. But due to questionable assumptions some claim the economy mayhave
grown at a much slower pace - 0.8% or less. (See:
nypostonline.com
The Commerce Department also reported that during June U.S. consumersshelled
out more money than ever -- for cars, household appliances and a hostof other
goods and services -- despite slowed growth in their incomes.Economists pay
close attention to spending habits because personal consumptionaccounts for
two-thirds of the U.S. economy. (See: washingtonpost.com
srv/WPlate/1998-08/04/116l-080498-idx.html)Political Speed Bumps
As long as foreign money continues to flow into the market, and U.S.consumers
continue to spend, the economy and market should do fine. On the otherhand,
political speed bumps may lie ahead to disrupt the confidence of foreign
investors and U.S. consumers.
According to well known financial journalist John Crudele "impeachment
hearings would be a horrible turn of events for both the stock and bond
markets. But even worse for investors could be the opportunistic movesthat
foreign governments, like Iraq, might make if the current politicalscandal
accelerates." (See: nypostonline.com
No-one knows what the Independent Counsel will report, but underSection 595c
of the Independent Counsel Act, he has the duty to prepare a report to
Congress only if he finds actions that are potentially impeachable.
Crudele notes: "Even before this week's deal with Lewinsky, NBC News was
reporting that this document was 300 pages thick. I can't argue withthat
since I've been writing for months that the report will be massive. That
means, of course, that Starr believes Clinton committed 300 pages worthof
offenses that can get him kicked out of office even before Lewinsky's
agreement entered the picture."
Crudele states that Starr has already told some of his investigativestaff
that they will be returning to their regular jobs as of September 1st -so
expect a report to Congress soon. At the very least a report wouldgenerate a
lot of political uncertainty and cloud the outlook for business, andwill
distract the Administration from important economic issues and Asia.
Asia Problems - Depression in Japan?
"Whether or not it is yet appropriate to use the word depression todescribe
Asia's worsening crisis, that's exactly what it is starting to looklike on
the ground" according to BusinessWeek's latest edition, and "Standard &Poor's
DRI estimates there is now a 20% to 25% chance of a depression in Japanitself."
Compounding the problem is the fact that Japanese voters and stockmarkets
have low expectations for the new Prime Minister - and in his maidenspeech
before parliament he proved unable to surpass them and has drawn heavy
criticism from political appointments. (See:
mercurycenter.com
Some have raised the question of whether deflation is being imported tothe
U.S. from Asia - and warn of the harm that deflation could cause to theU.S.
economy. (See:
boston.com
.shtml)Risk Not Insignificant
If the ongoing political problems in the U.S. create enough uncertaintyfor
foreign investors or U.S. customers to disrupt the flow of money intothe
market or the economy, the risk to the market - especially large caps -will
not be insignificant.*****************INVESTMENT ARTICLES ON THE INTERNET
We scan around 150 papers and magazines daily for investment articlesthat may
be of special interest to individual investors. Links to these articleson
investing, the economy, the market, internet commerce, Y2K, Asia, andother
topics, can be found at Mark Johnson's Internet Financial Connectionforum on
the Silicon Investor at
techstocks.com and
techstocks.com and
techstocks.com******************
MODEL PORTFOLIO UPDATEThe following was reported in earnings conference calls:
BIOSOURCE INTERNATIONAL (BIOI)
BIOI announced second quarter results earning ten cents a share - onecent
short of analyst estimates. For the first six months the company hasearned
$0.19. In the last 14 months the company has repurchased 1.1 millionshares,
12% of those outstanding. During the last quarter 450,000 shares were
repurchased at an average price of $6.74, and during the first half833,000
shares were repurchased at an average price of $6.69. Currently theirare 7.34
million shares outstanding.
Revenues for the quarter only increased 5% over year earlier levels,although
the U.S. sales were up 15%. Management expects double digit growth insales
for the rest of the year, and may look at hedging opportunities toreduce the
impact of currency fluctuations (half the company sales are in Europe).
Revenues in Europe were not helped by the strength of the dollar, andexcess
manufacturing capacity exists in the European operations which makescosts
higher than ideal.
The company introduced over 40 new products in the first half, andexpects to
introduce more in the second half. Two new products have significantpotential
in management's view - with a combined market of $13-16 million inwhich BIOI
expects to be extremely competitive. BIOI's products are not uniquetechnology
wise but are packaged differently, and they offer a wide breadth ofproducts
at competitive prices and expect to gain market share.
Financially the company retains strong cash flows and has a conservative
balance sheet. The company would not comment on a future buyback, andsaid
that the full weight of the buyback will be felt in the 1999 fiscalyear.
Recently competitor Techne acquired certain Genzyme products - so BIOInow
faces one competitor in many areas where they faced two before.Management
stated that Techne paid a significant price for what they got - most ofthe
products Techne bought they already had so they essentially boughtmarket
share. Note that Techne paid four times revenues - at four times salesBIOI
would be valued at $10-11 a share.
VectorVest has a fair value of $8.10 for BIOI; Money.com, using Zack's
earnings estimates of $0.43 for this fiscal year, has a fair value of$8.13.
BIOI closed Friday at $3.68, and sports a price to book ratio of 1.16.
SMARTFLEX SYSTEMS (SFLX)
SLFX announced second quarter results earning six cents a share - which
exceeded analyst estimates - on revenues that declined by 27%. Thecompany
noted that the hard disk drive (HDD) data storage industry - one of themajor
sectors that SFLX serves as a contract manufacturer - is continuing to
experience reduced demand, excess inventory, and cost pressures, with no
improvement apparent in the foreseeable future.
The company is working on 15 new projects - the most in quite some time- and
customers are increasingly implementing a "build to order" system thatmakes
backlogs less indicative of future business. This makes it moredifficult for
SFLX to project future demand.
The company is expanding the Cebu facility and has excess capacity attheir
Mexico facility, and the cost reduction program has been implementedwhich
allowed them to post positive earnings in a business environment thatis far
from ideal. The company has moved the break-even point downward, butsaid that
they are well positioned to handle any rebound in demand.
SFLX has a strong balance sheet with $4.72 of cash per share, and noborrowing
against its' $25 million line of credit.
The company announced some interesting developments regarding corporate
strategy and positioning. Management announced that they willaggressively
develop their electronic contract manufacturing services to a broadermarket
and provide engineering, technical, and design services. The companyplans on
adding technical capabilities and broadening the marketing focus andteam, and
said that they would like to enter the market to provide services to the
medical and telecom markets - these sectors generally need more designand
engineering work versus HDD customers.
VectorVest has a fair value for SFLX of $9.80. SFLX is not in theMoney.com
database. SFLX closed Friday at $7.25, and sports a price to book ratioof0.93.
INACOM CORPORATION (ICO)
ICO announced second quarter earnings of $0.62 meeting or exceedinganalyst
expectations for the 16th quarter in a row. The company reportedrevenues
increased 17% from year earlier levels. Service revenue grew at 41%compared
to year earlier levels, communication revenue grew 25%, and the hardware
revenue - the largest segment of revenues - grew at 15%.
The company continues to focus on the service and communicationssectors of
the business. These sectors contribute around 60% of the earnings, andshould
cushion any weakness in margins in the hardware sector.
While hardware shipments continue to increase, average selling pricescontinue
to decline. The company added 300 service specialists in the secondquarter in
addition to the 200 specialists added in the first quarter, and theyshould
become more productive in the third and fourth quarters. Managementindicated
that service and communications revenues should continue to expandstrongly,
with margins remaining relatively stable. ICO also recently acquiredTobek
Technical Services to expand the service segment of the business.
Money.com has a fair value of $51.92 for ICO and rates it a buy.VectorVest
has a fair value of $49.00 for ICO. ICO closed Friday at $26.62, andsports a
price to book ratio of 1.16.DYCOM INDUSTRIES (DY)
Dycom's revenues are expected to double in two years according to DYPresident
Steven Nielsen, as telecommunications mergers fuel increasedconstruction
spending. DY is the second-largest U.S. company in the business oflaying
cable for telephone companies, and expects to gain business in the nextyear
from AT&T's acquisition of Tele-Communications Inc. as well as fromother
pending mergers.VALUATION SITE
A site that may be a useful tool to calculate a "fair" valuation of aModel
Portfolio company or other stock - using analyst information and certain
assumptions about inflation - can be found at the Money.com site at
pathfinder.com**************
The information revolution has given us access to financial data thatwe hope
to use to identify promising investment opportunities. The Lone Starupdate is
a nonprofessional effort to help investment club members examine market
opportunities and strategies. It is a closed, confidential, moderatedmailing.
We think this information is correct, but as always check our reasoningand
analysis.*********Joe Dancy, EditorDoug Fant, Contributing Editor
Dave Kurtz, Contributing EditorAugust 15, 1998
Lone Star Growth Investor - Dallas, Texas |
