Introduction The Buffettology Workbook is designed to teach you the investment methodologies of Warren Buffett. Warren has never been the type of investor who "plays" the stock market. In fact, over the last forty years, he has made a point of dodging every popular investment mania to sweep Wall Street. Be it the Internet revolution or the biotech bonanza, he sat out all the big plays, never making, as he himself admits, one thin dime off any of them. Yet, in those years, as countless treasure-laden Wall Street ships slipped by, Warren managed to turn an initial investment of $105,000 into a fortune exceeding $30 billion, solely by investing in the stock market. His investment feat is unparalleled in the history of Wall Street. How did Warren Buffett become a multibillionaire, King of the Street, without making any money off any of the big Wall Street plays? It's an interesting question. The answer may not be obvious but it is simple: Warren Buffett got super rich not by playing the stock market (you heard me right, he doesn't play the stock market) but by playing the people and institutions that play the stock market. Warren is the ultimate exploiter of the folly that results from other investors' short-sightedness. The people and institutions that play the stock market in search of quick profits will at some point (we can assure you) commit acts of short-sightedness that ultimately collapse into investment foolishness. When they do, Warren is there waiting, patiently, to take advantage of them. It sounds predatory, doesn't it? It is. Warren is able to do this better than anyone else because he discovered something that very few people appreciate, that approximately 95% of the people and investment institutions that make up the stock market are what he calls "short-term motivated." They respond to short-term stimuli -- they buy on good news and sell on bad. The good news can be as complex as a prospective buyout looming on the horizon or as simple as a quarterly increase in earnings or a quickly rising stock price. The bad news can be anything from a major industry recession to simply missing a quarterly earnings projection by a few cents. Warren realized that an enthusiastic stock price, when coupled with good news about a company, was often enough to help push the price of a company's shares into the stratosphere. This is commonly referred to as the "good news phenomenon." He also saw that the opposite happened when the situation was reversed. A pessimistic price, when coupled with negative news about a company, will send its stock into a tailspin. This is, of course, the "bad news phenomenon." Warren discovered that in both situations the underlying long-term economic value of the company's business is often totally ignored. The short-term mentality of the stock market sometimes grossly overvalues a company, just as it sometimes grossly undervalues a company. Warren also observed that, over time, it is the long-term economic value of a business that levels the playing field and ultimately causes the stock market to properly value the company relative to its long-term worth as a business enterprise. Warren has found that businesses that the stock market has overvalued are eventually revalued downward, making their shareholders poorer. This means that many a fashionable investment ends up in the dumps, costing its shareholders their fortunes, rather than earning them a bonanza. He also discovered that many overlooked and undervalued businesses are eventually revalued upward, making their shareholders richer. Which means a current stock market pariah can often end up tomorrow's shining star. The aspect of this treasure hunt that intrigues Warren, and where he made the majority of his money, is when the short-term market mentality grossly undervalues a great business. He has determined that the stock market will sometimes overreact to bad news about a great business and rush to sell its stock, making it a bargain buy for the few who value the stock based on its predictable long-term economics. (Remember, the vast majority of people and institutions, like mutual fund managers, sell on bad news.) When this happens to a stock that Warren is watching, he goes into market and buys as many shares as he can, knowing that over time, the long-term economics of the business will eventually correct the negative situation and return the stock's price to more profitable ground. Warren, unlike the vast majority of the market, loves to buy on bad news. He shops when the stocks are unpopular and the prices are cheap -- when short-term doom and gloom blinds Wall Street's eyes to the predictable long-term economic value of a great business. Speculating in good news bull markets is something that Warren leaves to the other guys. It's not his game. He never owned Yahoo!, Lucent Technologies, CMGI, or any of the other high-flying high-tech companies that were all the rage of the Internet bubble. Warren's game is to avoid popular stocks, wait for short-term bad news to drive down the price of some fantastic business, then jump on it with a ton of cash, buying as many shares as he can. The Buffettology Workbook is designed to teach you tools that will give you the kind of conviction that Warren has to charge ahead where others fear to tread. We'll take you step by step through the methodology and financial equations Warren uses, not only to determine what companies to invest in, but also when to invest in them. Simply knowing what types of companies have excellent long-term economics working in their favor is not enough. You also have to know how to determine the right price to pay for them. Pay too high a price and it doesn't matter how great an economic engine the company has working for you, your investment return is forever moored to the dock of poor results. Pay a low enough price for the right business and you too can sail away with the riches of King Solomon, just as Warren has. The first part of this book focuses on the qualitative side of the equation. This is where you'll learn how Warren identifies the power and quality of a company's long-term economics. It explains how he determines whether or not the company's economic machinery is sound enough to weather the storm that brought the company's stock price down in the first place. You will come to see that Warren's genius lies in his ability to grasp the long-term economic worth of a handful of great businesses and why they are sometimes oversold by the stock market. The second part is quantitative. This is where you will learn to use the mathematical equations that Warren uses to determine how much to pay for one of these great businesses. Warren will only invest in a company when it makes business sense, when he can get it at the right price, as determined by projecting an annual compounding rate of return for the investment. This projected annual compounding rate of return is ascertained by performing a series of calculations that we will teach you how to do. To facilitate the number crunching, we incorporate into the book the use of a Texas Instruments BA-35 Solar financial calculator. Thirty years ago these marvelous little wonders didn't exist, but thanks to the brilliance of Texas Instruments, a world that once belonged only to Wall Street analysts is now accessible and understandable to anyone. So if you are afraid of financial math -- don't be; we've got you covered and in no time you'll be making financial projections just like you-know-who. (Please note: Though we have designed the workbook around the use of this particular calculator, any financial calculator that performs present and future value calculations will suffice.) At the end of the book we have created several case studies and a special template for you to use to facilitate the use of Warren's methodology and intrinsic value equations. This will enable you to work through a set of specific questions and calculations to help you obtain Warren's unique perspective. Those of you who have read Buffettology will find that the Workbook will give you a very different, but enlightening, perspective on Warren Buffett's investment methods. We have revisited many of the original Buffettology case studies to determine whether our past analysis was on the money. (It was and still is.) We also explore how Internet trading companies have made stock arbitrage a lucrative venture for even the smallest of individual investors. For those of you who haven't read Buffettology, we can think of no better primer than the Workbook. Each book complements the other; reading both should give you a deeper and more profitable understanding of Warren Buffett's investment techniques. While Buffettology focused on Warren's use of Business Perspective Investing, the Workbook takes an in-depth look at just how he uses the stock market's short-term mentality to reap unheard-of riches. You will learn that this short-term mentality has permeated every corner of the investment world, and that if it didn't exist, Warren would never have made a penny. But it does and he has used it to create one of the great fortunes of all time. Please don't be misled. Warren's methods are fairly simple to grasp, but they do go against basic human intuition. The learning part is easy. The implementation is far more difficult. This book will be read and understood by many, but few will have the courage to implement its methods. Buying on bad news is much harder than it sounds. The few who come to understand his methods and develop the backbone to implement them will soon discover a bottomless well of wealth into which they may dip for the rest of their lives. So let's get out the calculator, sharpen a pencil or two, find a clean piece of paper, and start calculating our way to your first billion! KEY POINTS FROM THIS CHAPTER Warren is not interested in popular investments such as Internet companies. Warren discovered that the vast majority of stock market investors are short-term oriented, that they buy on good news and sell on bad. The short-term stock market mentality sometimes grossly undervalues the long-term prospects of a great business. When it does this, Warren becomes interested. Warren likes to buy on bad news. Warren's genius lies in his ability to grasp other people's ignorance about the long-term economic worth of certain businesses. Study Questions Are you more comfortable buying on good or bad news? Why? Is Warren more interested in buying on good or bad news? Why? Why do you think that most investors ignore the long term and focus on the short term? Have you ever wished you had the courage to invest in a company after the market tanked its stock? What was the company's name and how much money would you have made if you had bought and held? True or False 1. T or F Warren is interested in buying Internet stocks that are grossly overvalued. 2. T or F The time Warren becomes interested in a company is when it has just announced good news about the business and the price of its shares responds by jumping upward. 3. T or F The stock market sometimes undervalues a company from a long-term perspective. 4. T or F Even great businesses can fall prey to the "bad news phenomenon." Answers: 1. False 2. False 3. True 4. True Copyright © 2001 by Mary Buffett and David Clark Chapter One: Short-Sightedness and the Bad News Phenomenon: The Gifts That Keep On Giving Short-sightedness and the bad news phenomenon. What are these things and what do they have to do with Warren Buffett? The answer is everything. If the vast majority of the stock market were not short-sighted, Warren Buffett would never have an opportunity to buy some of the world's greatest businesses at discount prices. He could never have bought 1.7 million shares of The Washington Post twenty-seven years ago for approximately $6.14 a share. The Washington Post now trades at approximately $500 a share, which makes his $10.2 million initial investment worth approximately $863.8 million today. That equates to a pretax annual compounding rate of return of 17.8%. Without the short-sightedness of the stock market, Warren could not have bought Coca-Cola for $5.22 a share twelve years ago. It now trades at approximately $50 a share, which equates to a pretax annual compounding rate of return of approximately 21%. Warren discovered early on in his career that 95% of the participants in the stock market, from Internet day traders to mutual fund managers who manage billions, are only interested in making a quick buck. Yes, some pay lip service to the importance of long-term investing, but in truth they are stuck on making fast money. Warren found that no matter how intelligent a person is, the nature of the beast controls the investor's actions. Take mutual fund managers. If you talk to any of them, they will tell you that they are under great pressure to produce the highest yearly results possible. This is because mutual funds are marketed to a lay public that is only interested in investing in funds that earn top performance ratings in any given year. Imagine a mutual fund manager telling his or her marketing team that their fund ranked in the bottom 10% for performance out of all the mutual funds in America. Do you think the marketing team would jump up and down with joy and go out and drop a couple of million on advertising to let the world know that their fund ranked in the bottom 10%? No. More likely our underperforming fund manager would lose his or her job and some promising young hot shot would take over the fund's investment allocations. Don't believe it? Ask people you know why they chose to invest in a particular mutual fund and they will more than likely tell you it was because the fund was ranked as a top performer. The nature of the mutual fund beast influences a lot of very smart people into playing a short-term game with enormous amounts of capital. No matter what fund managers' personal convictions may be, producing the best short-term results possible is the way to keep their job. Warren also discovered that investors who get caught up playing a short-term game have very human reactions whenever they hear bad news about a company in which they own shares -- they sell them. To make the big bucks in the short-term game, the investor has to be one of the first to get in on the stock before it moves up, and one of first to get out before it moves down. Having access to the most up-to-date information available is of utmost importance. A good earnings report and the stock price moves upward. A bad earnings report and it moves downward. It doesn't matter whether earnings will improve in a year or two. All that anybody is interested in is what is going to happen today. If things look great this week, people will buy the stock, and if they look bad next week, they will sell it. This is why mutual funds are notorious for having such high rates of investment turnover. They get in and out of a lot of different stocks in hopes of beating the other guys in the competition for the all-important title Top Fund of the Year. This "bad news phenomenon" -- the selling of shares on bad news -- is one constant in the ever-changing world of stock market trading. Watch any nightly business report on television and you'll see that after any negative news about a company is announced, the price of its shares drops. If the news is really bad, the shares will drop like a rock. It's the nature of the beast. Bad news means falling share prices; bad news means that Warren's eyes light up. To Warren, the short-sightedness of the stock market, when combined with the bad news phenomenon, is the gift that keeps on giving. This combination of factors has produced for him one great buying opportunity after another, year after year, decade after decade, to the happy tune of $30 billion. Before we jump to the next chapter, we'll let you in on one of Warren's best-kept secrets. He figured out that some, but not all, companies have economic engines that are so powerful they can pull themselves out of almost any kind of bad news mud that the short-sightedness of the stock market gets them stuck in. He has developed a specific list of criteria to help him identify those businesses. When these businesses are hit with bad news and the short-sighted stock market hammers their stock prices, he steps in and buys like crazy. He calls these wonderfully resilient businesses "consumer monopolies." Warren made all his big money by investing in consumer monopolies. They are the Holy Grail of his investment philosophy and we predict that they will be the next great love of your investment life as well. KEY POINTS FROM THIS CHAPTER Warren discovered that everyone from mutual fund managers to Internet day traders are stuck playing the short-term game. It is the nature of the stock market. The bad news phenomenon is a constant -- people sell on bad news. Companies that have consumer monopolies have the economic power to pull themselves out of most bad news situations. Warren made all his big money investing in consumer monopolies. Study Questions Why are most mutual funds fixated on short-term results? How does Warren use a long-term perspective to exploit the stock market's short sightedness? True or False Questions 1. T or F Mutual fund managers are short-term motivated because they market their products to an investment public that is extremely short-sighted. 2. T or F The majority of the investing public sells on bad news and buys on good. 3. T or F Warren buys on bad news. 4. T or F Consumer monopolies have the strong economic engines. Answers: 1. True 2. True 3. True 4. True Copyright © 2001 by Mary Buffett and David Clark Chapter Two: Identifying the Economic Engine Warren Wants to Own What are the characteristics of the businesses that Warren Buffett wants to invest in? After more than forty-five years of actively investing in common stocks, Warren has discovered that if you want to take advantage of the stock market's short-sightedness, coupled with the bad news phenomenon, you must invest in companies with economics that will let them survive and prosper beyond the negative news that created the original buying situation. Remember, Warren is an exploiter of the investors and mutual funds that sell their shares on bad news. To do this he has to make sure that the company he is investing in is not only an intrinsically sound enterprise, but also has the economic ability to excel and earn fantastic profits. Warren isn't only interested in bottom picking. He's interested in using the market's mistakes to become the owner of some of America's greatest business enterprises at bargain prices. By picking only the cream of the crop, he is able to ensure that over a period of time the share price will not only fully recover, but will continue its upward trajectory. It is nothing for Warren to see a dramatic increase in the value of one of these great business after he buys in. In the case of Geico he saw a 5,230% increase in value. And with The Washington Post he did even better, clocking in with a 7,930% increase in value. It's mind-blowing, isn't it? He bought into these companies at a time when all of Wall Street was running from them as if they had the plague. He held on to them, because they were fantastic businesses that had the kind of economics working in their favor that over time would make him tremendously wealthy. Think of it this way. You have two racehorses. One, called Healthy, has a great track record with lots of wins. The other, Sickly, has a less than average track record. Both manage to catch the flu and are out of action for a year. The value on both shrinks because neither is going to win any money this racing season. So their owners, intending to cut their losses, offer them up for sale. Which would you want to invest your money in? Healthy or Sickly? It's not hard to see that Healthy is the best bet. First of all, you know that Healthy is fundamentally a strong horse. Not only does Healthy have a better chance of recovering from the flu than Sickly does, but afterward Healthy will be winning lots of races and make you tons of money! Even if Sickly recovers, the horse will more than likely remain true to its name and get sick again and again. The return on your investment will be like Sickly's health -- poor. Warren has separated the world of business into two different categories. The first one is the sickly kind; these are companies that have poor economics working in their favor. He refers to these as "commodity" type businesses. A commodity type of business manufactures or sells a generic product that a lot of other businesses also make or sell. The second type of business is the healthy kind, which has terrific business economics working in its favor. Think of Coca-Cola, Geico, and The Washington Post. He calls these companies "consumer monopolies." A consumer monopoly is the kind of business that sells a brand name product or has a unique position in the stream of commerce that allows it to act like a monopoly. Thus, if you want that particular product or to use a company's specific service, you have to purchase it from that company and no one else. This gives the company the freedom to raise prices and have higher earnings. These companies also have the greatest potential for long-term economic growth. They experience fewer ups and downs in business and they possess the wherewithal to weather the storms that a short-sighted stock market invariably overreacts to. First things first. Warren believes that unless you can identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market. You have to know what a commodity type business is and be able to identify its characteristics. If you don't, you just may end up owning one. You also have to be able to identify what a consumer monopoly type business is and be able to identify its characteristics, because this is the type of business that will make you a pot of gold. Let's take a deeper look into both these kinds of businesses, so you will be able to determine which is which, and which one is going to make you rich. As Warren says: "A stock well bought never has to be sold." KEY POINTS FROM THIS CHAPTER Warren has separated the world of business into two different categories: the healthy consumer monopoly type business and the sick commodity type business. A consumer monopoly is a type of business that sells a brand name product or has a unique position that allows it to act like a monopoly. A commodity type business is the kind that manufactures a generic product or service that a lot of companies produce and sell. Warren believes that if you can't identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market. Study Questions Why has Warren divided the world of business into two categories? Can you think of a company that has a consumer monopoly? Can you think of a company that sells a commodity type of product? True or False 1. T or F Warren is interested in buying the sick commodity type of business. 2. T or F Warren is interested in buying the healthy consumer monopoly type business. 3. T or F A commodity type of business is the kind that manufactures a brand name product. 4. T or F A consumer monopoly type of business is the kind that manufactures a generic type of product. Answers: 1. False 2. True 3. False 4. False Copyright © 2001 by Mary Buffett and David Clark Excerpted from The Buffettology: Value Investing the Warren Buffett Way by Mary Buffett, David Clark All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.
