Why would Buffett buy Fossil

On a Previous post I had mentioned about the Sumzero challenge where the contestants are supposed to submit an Investment idea that they feel would be Buffett's next investment choice. After going through a list of around 50 shortlisted stocks I finally came to the conclusion of recommending Fossil. So Why would Buffett consider purchasing Fossil? (i) The business has huge moat. And its products would be in demand for decades to come. (ii) The business belongs to Jewelry industry that Buffett understands really well. This can be said by looking at Berkshire Hathaway Inc’s portfolio of Jewelry businesses.(iii)Balance sheet is strong. Business also generates healthy free cash and does not need any major incremental Working capital. Current RETURN ON EQUITY = 38%. (iv) Company has a Strong management in place. (v) The business is selling for a discount. As of April-4-2015 the stock was trading at $83.75. The fair value is between $132 and $102 per share. Let us look at each of the above point closely.

Updated - 03/16/2015  FOSL Valuation : $102.83/ share , Total value : $5.45 billions (Base FCF : $0.350 billions , multiple 15, Net book value for val : $0.20 billion) Shares oustanding :53 millions  LINKS SEC  Company FACTORS THAT ENHANCE THE MOAT OF THE BUSINESS BRAND STRENGTH: i) The FOSSIL brand has developed from its origin as a watch brand to encompass other accessory categories, including handbags, belts, small leather goods, jewelry, soft accessories, sunglasses and clothing. ii) Since its inception in 1984, they have continued to develop, acquire or license other nationally or internationally recognized brand names, such as ADIDAS®, ARMANI EXCHANGE®, BURBERRY®, DIESEL®, DKNY®, EMPORIO ARMANI®, KARL LAGERFELD®, MARC BY MARC JACOBS™, MICHAEL KORS®, MICHELE®, RELIC®, SKAGEN®, TORY BURCH® and ZODIAC®, in order to appeal to a wide range of consumers. iii) Their industry is highly competitive and subject to changing preferences in style, taste and price points. By owning the vast majority of their global distribution, they are also able to create and execute consistent pricing strategies and brand image presentations that protect and enhance their proprietary brands and those of its licensors. LICENSING STRENGTH: i) Since 1997, they have attracted highly recognized and respected brand names to license within their watch and jewelry portfolios. They attract such quality brands due to their ability to provide them with access to their global design, production, distribution and marketing infrastructure. ii) As a result of their vertical integration, they, unlike many of their competitors, can offer an integrated solution to launch or increase an accessory category presence on a worldwide basis in a consistent, timely and focused manner. iii) All of its major licensing relationships are exclusive to them and the licensors, which substantially minimizes risks to the licensor associated with dealing with multiple licensees in different geographic regions. iv) Additionally, in order to develop a broader relationship and maintain brand consistency across the accessory categories, they have broadened their infrastructure, allowing them to expand their licensing activities to products beyond the watch category, including their DIESEL, DKNY, EMPORIO ARMANI and MICHAEL KORS jewelry product lines. BREADTH OF BRANDS AND RETAIL PRICE POINTS: i) Through the multiple brands they distribute, they have developed a broad spectrum of retail price points. Within their watch collections, core retail price points vary from approximately $7 in the mass market channel up to retail price points of $4,990 in the luxury distribution channel, although the majority of their collections focus on price points ranging from $85 to $600. ii) The breadth of their brands allows them to anchor a brand to a given price point range and distribution channel, thereby maintaining a consistent brand image while focusing on the quality/value relationship important to the customer and not diluting the brand through overlapping distribution channels. The breadth of price points allows them to cater to various age and income groups while continuing to participate in sales consistently, regardless of a shift in income or the price/value preferences of its customers. OPERATIONAL CONTROL: i) The three entities that assemble the majority of their Asia watch production volume are majority owned by them. In addition, although they do not have long-term contracts with their unrelated accessory manufacturers, they maintain long-term relationships with several manufacturers. These relationships developed due to the significant length of time they have conducted business with the same manufacturers. This helps them to exert significant operational control with regard to their principal watch assemblers. In addition the relative size of their business with non-owned watch manufacturers gives them priority within their production schedules. Furthermore, the manufacturers understand their quality standards, which allow them to produce quality products and reduce the delivery time to market, improving overall operating margins. ii) They distribute substantially all of their products sold in North America from their warehouse and distribution centers located in Texas. In Europe, they distribute their products primarily through their warehouse and distribution center located in Germany. Their centralized distribution capabilities in the U.S. and Europe enable them to reduce inventory risk, increase flexibility in achieving delivery requirements of their customers and maintain cost advantages as compared to their competitors. iii) HOW THE TEXAS WAREHOUSE IS USEFUL? Their warehouse and distribution facilities in Texas operate in a special purpose sub-zone established by the U.S. Department of Commerce Foreign Trade Zone Board. This sub-zone provides the following economic and operational advantages to them: (a) They do not have to pay duty on imported merchandise until it leaves the sub-zone and enters the U.S. market, (b) They do not have to pay any U.S. duty on merchandise if the imported merchandise is subsequently shipped to locations outside the U.S. and (c) They do not have to pay local property tax on inventory located within the sub-zone. BERKSHIRE’S JEWELRY PORTFOLIO AND HOW FOSSIL WILL FIT IN? Berkshire’s Jewelry portfolio consists of: (i) Ben Bridge Jeweler (ii) Borsheims Fine Jewelry (iii) Helzberg Diamonds. Each of these businesses offers broad range of jewelry including fine watches. FOSSIL’s moat will complement the strengths of these businesses and in turn increase the value of Berkshire’s Jewelry portfolio. FINANCIAL STATEMENT ANALYSIS 1. GROWTH IN BOOK VALUE / SHARE: It’s the prime measure Buffett uses to measure Berkshire Hathaway inc’s progress. Thus we need to look at Fossil’s 10 year change in Book value per share. Book value per share grew from $7.27/share in 2005 to $18.53 in 2014 at a Compounded annual growth rate of 9.81% per year for last 10 years. 2. CHANGES IN WORKING CAPITAL AS COMPARED TO GROWTH IN SALES: As Buffett has mentioned in his letters before that his definition of an ideal company is something like See’s Candies that has steadily increased its Free cash flow with very minimal increase in working capital. Below table gives the formula for measuring changes in Working capital with respect to Sales. A : Current Assets B : Cash C : Current liabilities D = A - B - C E = Sales F = E/D For the years 2005 thru 2014 the value of 'F' has maintained a tight range between 3.89 and 5.10 last 10 years. This shows that the business does not need much increase in working capital. 3. FREE CASH FLOW FOR LAST 10 YEARS : The company's Free cash flow increased from $88 millions in the year 2006 to $288 millions in the year 2014. The agregate Free cash flow during this period is $1,615 million. The Free cash flow has increased with a CAGR of 13.86% 4. RETURN ON EQUITY: Buffett has often stressed on a healthy Return on Equity as one of his yardstick in measuring a performance of a business. Fossil’s current ROE is 38%. In 2005 it was 14.31% and has constantly been increasing every year since then. This indicates a very positive sign that the business needs very limited capital to grow. A LOOK AT THE COMPANY’S MANAGEMENT: Fossil Group was founded in 1984 by Tom Kartsotis . His brother Kosta Kartsotis is the CEO and Chairman of the board. He owns 12% of the company and is said to be one of the lowest paid CEOs of any large organization. This shows his conservative style of managing capital. It very well matches Buffett’s style of functioning. VALUATION OF FOSSIL: Following are the assumptions for valuation of Fossil i) Base Free cash flow: $300 million. ii) Growth rate for next 10 years : Higher range 10% , Lower range 7% iii) Growth rate beyond 10 years to 25 years : Higher range 5% , lower range 2% iv) Terminal Value at end of 25th year = Current tangible book value. = $610 million. v) Discount rate = 8%. vi) Shares outstanding = 53.08 million Applying the Discounted Cash flow valuation technique, we get the following ranges HIGHER RANGE: (A) Sum of Discounted Cash flows for 25 years = $6,448.03 million. (B) Terminal Value = $610 million (A) + (B) = Fair Value = $7,058.03 millions Fair value / share = ($7,058.03 millions / 53.08 millions ) = $132.97 / share. LOWER RANGE: (A) Sum of Discounted Cash flows for 25 years = $4,817.51 million. (B) Terminal Value = $610 million (A) + (B) = Fair Value = $5,427.51 millions Fair value / share = ($5,427.51 millions / 53.08 millions) = $102.25 / share.

Sumzero Buffett Challenge

Other day while watching CNBC I stumbled upon a Competition organized by the web site Sumzero. It has announced a very interesting Competition that is titled “What will be Buffett’s next large investment?”. The participants need to pick one publicly traded stock and pitch in their idea as to why they think that Buffett would invest in it. Being a humble follower of the Master I thought of giving it a try. As a first step I have listed down a list of Investment candidates along with their quick valuation. Next couple of weeks I would do a deeper dive in these stocks and finally pick one as my entry to the Competition. Please click at Discounted cash flow basics to understand the valuation technique used for valuing the stocks.

Company list   Roper Industries   Fastnel   Timken   RBC Bearings   Precision Cast Parts   Toro Company   Stericycle   Harley Davidson   Fossil   Mead Johnson   Diageo   Constellation Brands   CH Robinson Worldwide   Expeditor's International   Genuine Parts co   Henry Schein   Patterson Companies   Westinghouse Brakes   Hertz   Avis Budget   Oceaneering Intl   Corelabs   Carbo Ceramics   PPG Industries   Energizer Holdings   Franklin Templeton   Coach   Ralph Lauren   Paccar   Oshkosh   Polaris Ind   Thor Industries   Avery Dennison   Calmine Foods   Johnson Controls   Borgwarner   Autoliv   Lear Corp   Allison Transmission   LKQ corp   GNTX   Dana Holdings   Gentherm   Dorman Updated - 03/16/2015  ROP Valuation : $39.00 / share , Total value : $3.90 billions (Base FCF : $0.5 billions , multiple 12 , Net book value for val : -$2.10 billion) Shares oustanding :100 millions  LINKS SEC  Company Updated - 03/16/2015  FAST Valuation : $23.73 / share , Total value : $7.00 billions (Base FCF : $0.400 billions , multiple 15 , Net book value for val : $1.0 billion) Shares oustanding :295 millions  LINKS SEC  Company Updated - 03/16/2015  TKR Valuation : $27.27 / share , Total value : $2.40 billions (Base FCF : $0.200 billions , multiple 12 , Net book value for val : $2.40 billion) Shares oustanding :88 millions  LINKS SEC  Company Updated - 03/16/2015  ROLL Valuation : $35.00 / share , Total value : $0.81 billions (Base FCF : $0.040 billions , multiple 12 , Net book value for val : $0.33 billion) Shares oustanding :23 millions  LINKS SEC  Company Updated - 03/16/2015  PCP Valuation : $104.23 / share , Total value : $14.80 billions (Base FCF : $1.20 billions , multiple 14 , Net book value for val : -$2 billion) Shares oustanding :142 millions  LINKS SEC  Company Updated - 03/16/2015  TTC Valuation : $40.91 / share , Total value : $2.25 billions (Base FCF : $0.150 billions , multiple 15 , Net book value for val : $0 billion) Shares oustanding :55 millions  LINKS SEC  Company Updated - 03/16/2015  SRCL Valuation : $22.35 / share , Total value : $1.90 billions (Base FCF : $0.325 billions , multiple 12, Net book value for val : -$2.0 billion) Shares oustanding :85 millions  LINKS SEC  Company Updated - 03/16/2015  HOG Valuation : $43.13 / share , Total value : $9.10 billions (Base FCF : $0.800 billions , multiple 14, Net book value for val : -$2.10 billion) Shares oustanding :211 millions  LINKS SEC  Company Updated - 03/16/2015  FOSL Valuation : $102.83/ share , Total value : $5.45 billions (Base FCF : $0.350 billions , multiple 15, Net book value for val : $0.20 billion) Shares oustanding :53 millions  LINKS SEC  Company Updated - 03/16/2015  MJN Valuation : $33.17 / share , Total value : $6.70 billions (Base FCF : $0.625 billions , multiple 12, Net book value for val : -$0.80 billion) Shares oustanding :202 millions  LINKS SEC  Company Updated - 03/16/2015  DEO Valuation : $12.00 / share , Total value : $7.50 billions (Base FCF : $1.50 billions , multiple 13, Net book value for val : -$12.00 billion) Shares oustanding :625 millions  LINKS SEC  Company Updated - 03/16/2015  STZ Valuation : $27.50 / share , Total value : $2.20 billions (Base FCF : $0.600 billions , multiple 13, Net book value for val : -$5.60 billion) Shares oustanding :80 millions  LINKS SEC  Company Updated - 03/16/2015  CHRW Valuation : $51.72 / share , Total value : $7.50 billions (Base FCF : $0.500 billions , multiple 15, Net book value for val : $0 billion) Shares oustanding :145 millions  LINKS SEC  Company Updated - 03/16/2015  EXPD Valuation : $32.91 / share , Total value : $6.45 billions (Base FCF : $0.350 billions , multiple 15, Net book value for val : $1.20 billion) Shares oustanding :196 millions  LINKS SEC  Company Updated - 03/16/2015  GPC Valuation : $52.29 / share , Total value : $8.00 billions (Base FCF : $0.600 billions , multiple 12, Net book value for val : $0.80 billion) Shares oustanding :153 millions  LINKS SEC  Company Updated - 03/16/2015  HSIC Valuation : $66.07 / share , Total value : $5.55 billions (Base FCF : $0.450 billions , multiple 13, Net book value for val : -$0.30 billion) Shares oustanding :84 millions  LINKS SEC  Company Updated - 03/16/2015  PDCO Valuation : $25.00 / share , Total value : $2.60 billions (Base FCF : $0.200 billions , multiple 13, Net book value for val : $0.00 billion) Shares oustanding :104 millions  LINKS SEC  Company Updated - 03/16/2015  WAB Valuation : $51.04 / share , Total value : $4.90 billions (Base FCF : $0.400 billions , multiple 12, Net book value for val : $0.10 billion) Shares oustanding :96 millions  LINKS SEC  Company Updated - 03/16/2015  HTZ Valuation : $17.78 / share , Total value : $8.00 billions (Base FCF : $2.80 billions , multiple 10, Net book value for val : -$20.00 billion) Shares oustanding :450 millions  LINKS SEC  Company Updated - 03/16/2015  CAR Valuation : $48.18 / share , Total value : $6.60 billions (Base FCF : $1.80 billions , multiple 12, Net book value for val : -$15.00 billion) Shares oustanding :137 millions  LINKS SEC  Company Updated - 03/16/2015  OII Valuation : $56.57 / share , Total value : $5.60 billions (Base FCF : $0.400 billions , multiple 14, Net book value for val : $0 billion) Shares oustanding :99 millions  LINKS SEC  Company Updated - 03/16/2015  CLB Valuation : $115.91 / share , Total value : $5.10 billions (Base FCF : $0.265 billions , multiple 20, Net book value for val : -$0.20 billion) Shares oustanding :44 millions  LINKS SEC  Company Updated - 03/16/2015  CRR Valuation : $32.61 / share , Total value : $0.75 billions (Base FCF : $0.050 billions , multiple 10, Net book value for val : $0.25 billion) Shares oustanding :23 millions  LINKS SEC  Company Updated - 03/16/2015  PPG Valuation : $58.62 / share , Total value : $8.00 billions (Base FCF : $1.00 billions , multiple 13, Net book value for val : -$5.00 billion) Shares oustanding :136 millions  LINKS SEC  Company Updated - 03/16/2015  ENR Valuation : $76.92 / share , Total value : $5.00 billions (Base FCF : $0.500 billions , multiple 14, Net book value for val : -$2.00 billion) Shares oustanding :65 millions  LINKS SEC  Company Updated - 03/16/2015  BEN Valuation : $57.88 / share , Total value : $36.00 billions (Base FCF : $2.00 billions , multiple 14, Net book value for val : $8.00 billion) Shares oustanding :622 millions  LINKS SEC  Company Updated - 03/16/2015  COH Valuation : $37.45 / share , Total value : $10.30 billions (Base FCF : $0.800 billions , multiple 12, Net book value for val : $0.70 billion) Shares oustanding :275 millions  LINKS SEC  Company Updated - 03/16/2015  RL Valuation : $121.84 / share , Total value : $10.60 billions (Base FCF : $0.800 billions , multiple 12, Net book value for val : $1.00 billion) Shares oustanding :87 millions  LINKS SEC  Company Updated - 03/16/2015  PCAR Valuation : $70.90 / share , Total value : $25.10 billions (Base FCF : $1.800 billions , multiple 12, Net book value for val : $3.50 billion) Shares oustanding :354 millions  LINKS SEC  Company Updated - 03/16/2015  OSK Valuation : $41.77 / share , Total value : $3.30 billions (Base FCF : $0.300 billions , multiple 12, Net book value for val : -$0.30 billion) Shares oustanding :79 millions  LINKS SEC  Company Updated - 03/16/2015  PII Valuation : $51.52 / share , Total value : $3.40 billions (Base FCF : $0.300 billions , multiple 12, Net book value for val : -$0.20 billion) Shares oustanding :66 millions  LINKS SEC  Company Updated - 03/16/2015  THO Valuation : $34.72 / share , Total value : $1.84 billions (Base FCF : $0.120 billions , multiple 12, Net book value for val : $0.40 billion) Shares oustanding :53 millions  LINKS SEC  Company Updated - 03/16/2015  AVY Valuation : $14.44 / share , Total value : $1.30 billions (Base FCF : $0.250 billions , multiple 10, Net book value for val : -$1.20 billion) Shares oustanding :90 millions  LINKS SEC  Company Updated - 03/16/2015  CALM Valuation : $19.79 / share , Total value : $0.95 billions (Base FCF : $0.060 billions , multiple 12, Net book value for val : -$0.23 billion) Shares oustanding :48 millions  LINKS SEC  Company Updated - 03/16/2015  JCI Valuation : $9.61 / share , Total value : $6.40 billions (Base FCF : $1.20 billions , multiple 12, Net book value for val : -$8.00 billion) Shares oustanding :666 millions  LINKS SEC  Company Updated - 03/16/2015  BWA Valuation : $26.55 / share , Total value : $6.00 billions (Base FCF : $0.600 billions , multiple 11, Net book value for val : -$0.60 billion) Shares oustanding :226 millions  LINKS SEC  Company Updated - 03/16/2015  ALV Valuation : $31.25 / share , Total value : $2.75 billions (Base FCF : $0.250 billions , multiple 10, Net book value for val : $0 billion) Shares oustanding :90 millions  LINKS SEC  Company Updated - 03/16/2015  LEA Valuation : $67.95 / share , Total value : $5.30 billions (Base FCF : $0.500 billions , multiple 12, Net book value for val : -$0.70 billion) Shares oustanding :78 millions  LINKS SEC  Company Updated - 03/16/2015  ALSN Valuation : $14.58 / share , Total value : $2.63 billions (Base FCF : $0.475 billions , multiple 11, Net book value for val : -$2.60 billion) Shares oustanding :180 millions  LINKS SEC  Company Updated - 03/16/2015  LKQ Valuation : $5.92 / share , Total value : $1.80 billions (Base FCF : $0.200 billions , multiple 11, Net book value for val : -$0.40 billion) Shares oustanding :304 millions  LINKS SEC  Company Updated - 03/16/2015  GNTX Valuation : $11.64 / share , Total value : $3.40 billions (Base FCF : $0.250 billions , multiple 12, Net book value for val : $0.40 billion) Shares oustanding :292 millions  LINKS SEC  Company Updated - 03/16/2015  DAN Valuation : $13.57 / share , Total value : $2.23 billions (Base FCF : $0.275 billions , multiple 11, Net book value for val : -$0.80 billion) Shares oustanding :164 millions  LINKS SEC  Company Updated - 03/16/2015  THRM Valuation : $14.57 / share , Total value : $0.510 billions (Base FCF : $0.040 billions , multiple 11, Net book value for val : $0.07 billion) Shares oustanding :35 millions  LINKS SEC  Company Updated - 03/16/2015  DORM Valuation : $32.29 / share , Total value : $1.13 billions (Base FCF : $0.060 billions , multiple 13, Net book value for val : $0.35 billion) Shares oustanding :35 millions  LINKS SEC  Company

Buffett's most important lesson to investors

Although each and every shareholder letter of the Oracle of Omaha is loathed with advice that would be valuable for generations to come. But I feel the advice he gave in his 2000 shareholder’s letter is the most valuable that all of us should adhere to. Especially when the market is at all time high.

Reference – Year 2000 shareholder’s letter (pages 13 and 14) Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C.(though he wasn’t smart enough to know it was 600 B.C.). The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. 1.How certain are you that there are indeed birds in the bush? 2.When will they emerge and how many will there be? 3.What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars. Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe. Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component usually a plus, sometimes a minus in the value equation. Alas, though Aesop’s proposition and the third variable that is, interest rates are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT (Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a wellfounded positive conclusion. But the investor does not need brilliance nor blinding insights. At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative. Now, speculation — in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it — is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home? The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands. Last year, we commented on the exuberance and, yes, it was irrational that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return. Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them. This surreal scene was accompanied by much loose talk about “value creation.” We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get. What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen. But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street a community in which quality control is not prized will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

Index of Buffet's wisdom

If you GOOGLE Buffett's investment advice you will get scores of links, ironically none of those results actually link to Buffett’s shareholder's letters - the source of all the investment advice, which to me is as pure as the water of Gangotri (Origin of River Ganges). Thus I thought of creating this post that lists down some of Buffett's most important advice to common investors. I have also linked the relevant year's shareholder letter that explains that topic in detail. Every once in a while I browse through these letters and get enlightened by his thoughts.

1. How stock markets work and how we can benefit from it – 1987 2. What kind of companies does Buffett prefer to invest? – 1987 3. What an investor should know and his basic goal towards investing. – 1996 4. How to value an asset Using the philosophy “Bird in the hand is worth two in the bush”. 2000 5. What’s difference between Investment and speculation? 2000 6. Growth and value investing are same. 2000 7. How Buffett and Munger view themselves while analyzing stocks? – 1987 8. SATIRICAL – Why investment professionals behave as they do? – 1985 9. Even a great management cannot save a business with poor economics. 1985 10. How Buffett measures Long term results? - 1979 11. The value of a brand – case study of See’s candies – 1983 12. Economics of mergers and acquisitions. 1981 13. Economic Goodwill vs Accounting Goodwill – 1983 14. How an Insurance company can have lots of cash and still be broke – 1984 15. Buffett’s views on dividend policy – 1984 16. Cash flow is important , but don’t forget capital expenditures. - 1986 17. Difference between Book value and intrinsic value – 1987 18. Case studies of arbitrage opportunities : Rockwood / Arcata- 1988 19. Smart companies become aggressive when others are weak. How Berkshire profited in 1989 after Hurricane Hugo and California earthquake. 1989 20. Bond investing – 1989 21. What’s the trait of a good insurance company – 1990 22. Lesson on Banking business. 1990 23. Difference between franchise and a Business – 1991 24. Lesson on derivatives – 2002    2007 25. CASE STUDY - A business should stay simple – Mid American’s zinc fiasco – 2004 26. How super catastrophic premiums are recorded – 1992 27. How Float can be an asset for an Insurance company – 1997 28. Don’t just rely on accounting numbers- Look at the economic value Example of Scot Fetzer – 1986

LOGIC BEHIND BUFFETT'S DIET Following is what Buffett said in an interview with CNBC. "I get about 700, 750 calories a day from Coca-Cola," he says, often plowing through about five cans a day. "If you look at me, you're looking at about one-quarter Coca-Cola," Buffett joked. Yet Coke is not his only unique food selection: The 84-year-old also also feasts on Utz Potato Stix and, famously, ice cream. He defends adhering to what he calls "a happy diet," explaining there's a method behind it that involves actuary tables. "As I told people, I looked up mortality by age, and found six-year-olds died less than any other age group," Buffett said. "I'll eat what they eat."

Buffett's words of wisdom

Buffett's most valuable words of wisdom : Following are excerpts from Warren Buffett's shareholder letters that in essence are the most important investment tips a common investor can get from a person who has successfully practiced it for nearly 7 decades. How we should value an asset and difference between investment and speculation What an investor should know and his basic goal towards investing? How stock markets work? when should we buy the stock and when should we sell it?

How Buffett values an asset and Difference between investment and speculation REFERENCE - 2000 shareholder letter - Buffet’s core investing principle is just 2600 years old. Yes you are right its two thousand six hundred. He dates it back to Aesop who in 600BC had the principle “Bird in the hand is worth two in the bush”. This denotes a conservative way of looking at things and not being overly optimistic. An investor needs to ask himself: (i) How certain am I that there are birds in bush? (ii) When will they emerge and how many will they be? (iii) What’s the risk free interest rate? (Yield on long term US Treasuries) Over here Birds is just an example to prove the philosophy. We will need to replace it with dollars and in turn analyze the underlying business as to how much cash it’s going to generate in future and discount it with the risk free rate. It’s un-realistic to have a precise number but one can certainly get a range. So the underlying question is how to estimate the future cash flow? For this an investor needs to know different parameters influencing a business and estimate their future growth. In-contrast to investment, speculation does not pay any attention to the underlying asset. Its main goal is to guess what others are going to perceive the assets value. The line separating investment and speculation become blurred when more and more people join the speculation bandwagon. This is what happened in the internet bubble of late nineties where people used to boast of their portfolios being tripled in a year and anyone labeling it as speculative was called “an ignorant person who did not understand the power of internet” The years of 1999 and 2000 can be termed as a two year long party which was akin to behavior of Cinderella at the ball. Everyone knew that overstaying the festivity. That is continuing to value companies at around 200 times their earnings will eventually bring pumpkins and mice. But no one wanted to miss the grand party of the century. Each and every one at the party thought that he would just sneak out minutes before the midnight. But the problem was the clocks in the ball room didn’t have hands. What an investor should know and his basic goal towards investing REFERENCE - 1996 shareholder letter - Its often quoted by Buffett that intelligent investing needs an IQ of an average person but patience of an above average person. Following are couple of very simple rules. (i) KNOW YOUR CIRCLE OF COMPETENCE: If you think that you can invest in any stock that pops up on your screen then you are not investing but instead speculating. Let us look at this way. If an Engineer is looking for a job then he / she will mostly look for positions related to his field. He will not jump on a position of a Chef or a Tax consultant simply if they offered more pay. But when it comes to investing we just ignore this common sense and feel comfortable in investing in banks , oil companies , bio tech , consumer products , internet startups all at once. In fact there are people who rather prefer to invest in at least twenty different sectors so that they are diversified. But in reality they have very little knowledge about any of the underlying sectors. (ii) NO NEED OF UNDERSTANDING COMPLICATED JARGONS: One does not need to know any of the complicated jargons like beta , co-efficient , resistance level etc etc. The only thing one needs to know is how to effective evaluate future earning potential of a business. Only invest in that business when its selling at a discount. The underlying business needs to have long term prospects. If one is not comfortable owning the business for next 10 years then one need not invest for 10 minutes also. How stock markets work and how we can benefit from it?– when should we buy the stock and when should we sell it? REFERENCE - 1987 shareholder letter - This is the first question that pops up to any person who is new to investment world. The chances are more or less he will get it wrong the first time. Even Buffett was no exception in this rule. When at the age of 11 he bought his first stock of Cities services preferred for $38, he monitored the stock price every day. The stock price initially went down but eventually started rising. Buffett sold it at $40 later to realize that the stock soared to $200. This is when he realized that timing the market was not an efficient long term investing system. He later went on to study under Ben Graham and learnt that the stock quotes are delivered by a highly emotional person called “Mr. Market”. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him. Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you. But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy." In the short run, the market is a voting machine but in the long run it is a weighing machine. By this Ben Graham meant that the day to day swings in a stock price is mere reflection of people’s perception in the long term prospects of a business. But the long term price movements of a stock is indeed reflective of the underlying fundamentals of the business.

Buffett's first Million

As of March-2014, Warren Buffett’s net worth was $58.5billion (per Forbes magazine); this is despite giving over $20 billion to Gates Foundation. All this was started with a seed capital of $100. Its said that the first million is always the hardest. This article gives a detailed picture as to how Buffett earned his first million. References – 1. Warren Buffett – Making of an American Capitalist by Roger Lowenstein. 2. Warren Buffett’s letters to his partners.

Development of Buffett’s intrinsic value Roger Federer – All time Tennis legend made his Grand slam debut in 1998 and won his first grand slam title in Wimbledon 2003, since then he has repeated the feat 17 times (As of Mar-2014) If you are a very keen tennis follower you can notice that not much has changed in Federer’s game since 1998. He might have become slightly more mature, but his core game has been the same. Federer was four years old when he watched Boris Becker take his first title. He got fascinated by Tennis right away, he only took the sport seriously when he was 12 years old. Thus one can say that 90% of Federer’s intrinsic value grew in his teen years between the years 1993 and 1998. Like Tennis, Investment is also an art which needs years of hard work and dedication before the artist gets his first public acclamation. Warren Buffett is no different. His core competence was built long before the world first saw a glimpse of it. Warren’s core competence is his ability to grasp enormous amounts of information in very short time. This has helped him to build a mental image of the intrinsic values all the businesses that he follows. Thus when the market values these businesses at a discount, he naturally buys them. Warren’s father owned a securities business called Buffett-Falk. At an age when most children are busy chasing butterflies, Warren would be intrigued with the stock symbols of the S&P 500 guide and the numbers associated with them. His childhood friend Bob Russell would read out the names of cities and Buffett would spit out their populations. It seemed he never forgot any figure once he saw it. But more than everything he had an immense desire to become wealthy. As a kid Warren would go to the local racecourse Ak-Sar-Ben (Nebraska spelt in reverse order) and scout the dusty floors for stubs where once in a while he would get a winning ticket that was thrown out erroneously. Warren was cautious beyond his years. When he learnt to walk , it was with his knees bent as if ensuring that he wouldn’t fall. When Warren was six, his family went for a vacation to Lake Okoboji in Northern Iowa. Warren would buy a six pack coke for 25 cents and would sell them for five cents each, pocketing 20% return in one day. When Warren was seven he was hospitalized, he took a piece of paper and wrote a number with many zeroes and showed it to Nurse, stating that the number represented his future net worth. Such was his confidence!!! As a 10 year old Warren accompanied his dad to Wall Street. This is where he got the first glimpse of the Engine that propels the Capitalistic world. At the age of 11 he made his first stock investment. He bought 3 shares of Cities Services preferred for $38/share. The stock went down to $27 but soon recovered to $40. This is when he sold it, just to see the stock climb to $200. Thus he learnt his first investment lesson of not being impatient. Warren’s passion for probability pulled him to Ak-Sar-Ben Racetrack where he and his friend Russell developed a tipping system for horse players. They called it “Stable boy selections”. They tried selling copies of their system, but the authorities just shut them down as the boys did not possess proper license. At age of 13 Warren moved with his family to Washington as his father was elected to Congress. Warren took up a Newspaper route delivering Washington Post. He was meticulous to track his earnings and file a tax return. Warren’s grades were mediocre and he even once ran from his home. He was a rebellious kid. But his business passion was growing; he soon had five newspaper routes delivering 500 newspapers every day. An excerpt of this young business acumen is visible in his marketing strategy for selling magazines to his newspaper customers. Some of Warren’s customers left their magazines outside and Warren could tell by tearing off the address label when their subscriptions were ending. That is when Warren approached them with new subscriptions. The newspaper business soon blossomed; Warren was making $175 / month (equivalent to $2,625 in 2014). At the age of 14 he had accumulated $1,200 that he invested in forty acres of Nebraska Farmland. Warren and his friend Danly bought a pinball machine, the machine always needed some maintenance and Danly was great at it. Warren noticed Danly’s skills and thought of leveraging it with his business idea. He planned on renting out the machine to a local Barber shop. The deal was that the Barber shop would get the share of the Pinball’s earnings. The business was super success. They soon had seven such machines in different Barber shops. Warren and his friend Danly were making $50 / week. By the time Warren was in his senior year of High school, he had decided on a career in Investing. He would scour through the business page, gleaning at Stock prices. The word of his expertise spread in his school and people were convinced that he knew what he was talking about. Warren graduated from high school in 1947 finishing 16th out of total 347 students. The High School yearbook stated “Likes Math……a future stockbroker”. Chiseling of the great Investment mind By 1950 Warren had accumulated $9,800 from his various little businesses. This is when he stumbled upon Graham’s book “Intelligent Investor”. Graham’s principles struck him straightway. Warren knew that if he wanted to make it big in the Investment world then he needed a mentor, a person who would shower him with the Investment acumen, which would give him that vital extra edge over other investors. They say things happen for a reason, In Warren’s case it was definitely true. He first applied at Harvard and was rejected because the Harvard folks did not find him as a perfect match. Warren then applied at Columbia where Graham was the dean of Securities profession. Warren got the nod from the school and he was heading to New York. Not realizing that his experience there would change his life forever. Graham’s class of 1950 had 20 students; Warren was the youngest amongst them. Graham’s style of teaching involved asking questions to his pupils. Even before Graham had finished his question Warren would raise his hand. Graham wouldn’t say yes or no to the answer, instead would drill down to get the reasoning behind Warren’s answers. Warren passionately followed up with a logical explanation for his answer. The great thing about Graham was that he did not toil on past case studies; instead lectured on stocks those were active. One of Warren’s class mates Marshall Weinberg would later comment that through Graham’s lectures he came to know about cheap stocks like Youngstown sheet & tube, Real Silk Hosiery. He bought these stocks and later profited through them. These stock tips itself paid for his degree. Buffett wanted to know about everything that Graham was associated with. He soon found out that Graham was Chairman of GEICO. On a Saturday morning Buffett boarded a train to its headquarters in Washington. Buffett banged the door of the office until a janitor opened for him. He wanted to know if there was anyone in office he could talk to. Janitor took him to 6th floor where Lorimer Davidson was working. Davvy as he was called by his friends was thrilled to hear complex business questions from a young MBA student. He was impressed with Buffett’s thirst for knowledge and spent four hours going over some intricate topics on Insurance business. Buffett graduated with A+, the only student to have received that honor from Graham in his 22 years of teaching career. Buffett was eager to put his new found Investment knowledge to work. He offered to work for Graham-Newman for FREE. But surprisingly was turned down. Buffett was saddened to hear this, but did not give up his determination. Though he was disheartened to know the reason behind the refusal, it was because Jews were not welcomed in Wall Street firms thus Graham wanted to reserve the spot for a Jew. Buffett headed back to Omaha and joined his father’s investment firm Buffett & Falk. In April 1952 he married Susie and they rented a three room apartment for $65/ month rent. Buffett’s job at his father’s firm was to research investment ideas and sell to his customers. They saw him as a young in-experienced analyst and did not take his investment ideas seriously. Buffett’s best investment that time was the public speaking class at Dale Carnegie. This gave him confidence to speak in public. He made best use of it by teaching a night class on “Investment principles” at University of Omaha. His students were mostly established professionals like doctors who were twice his age. But they immediately were connected to these investment principles that were scooped out of Graham’s playbook. Buffett’s stars again took a turn; he got an offer from Graham-Newman to work for the firm. Graham had dropped the religious barrier. Graham-Newman was operating a mutual fund that bought stocks based on some very rigid principles. One of Graham’s favorites was to look for stocks that were trading at one third less than their working capital. Because of these rigid rules, a lot of Buffett’s investment ideas were rejected by the fund. One such idea was Home protective insurance. Buffett bought it at $15/share and saw it rise to $70/share. His confidence was growing day by day. Graham retired in 1956; his Investment firm had racked 17% annual returns (1936-1956). In the meantime Buffett had laid the solid foundation for his future endeavor. He had successfully tested his investment system by validating its theory; his net worth had grown from $9,800 to $140,000 (equivalent to $2.2mn in 2014) Buffett Partnerships May-1-1956: Warren Buffett, a green 26 year old money manager begins his journey to one of the most spectacular and most followed upon business journeys of American Capitalism. He puts in $100 (Yeah, no zeroes missing, just $100) to form an Investment partnership. His seven initial investment partners were his sister Doris and her husband, Aunt Alice, Doc Thompson, his ex-roommate Chuck Peterson and his mother and Dan Monen his lawyer. Together the seven partners put in $105,000. Very soon few more investors joined in and Buffett was running three small partnerships. PARTNERSHIP’S INVESTMENT STRATEGY (Reference – letters to Buffett Partnership members 01/18/1963) Buffett allocated the assets of partnership into following kinds of investments. Undervalued Securities These he referred to as “generals” , because he had no control over the corporate policies of these companies and no time table as to when the undervaluation would correct itself. By 1962 this had slowly become the largest category of investment and he made more money here than in either of other categories. He allocated 5 % to 10% of total assets in each of five or six generals , with smaller positions in another ten or fifteen. It’s important to note that Buffett did not buy them because he saw any immediate catalyst and had no idea when the prices would appreciate. While investing in this group , he also sometimes followed the strategy of “coattail riding” where he felt that dominating stockholder group had plans for the conversion of unprofitable or under-utilized assets to a better use. In other words he planned his moves with the motive of leveraging on other activist investor's actions. Following are some very interesting words that outline this strategy. “Many times generals represent a form of “coattail riding” where we feel dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.” Workouts These are securities whose financial results depend upon some corporate action like mergers , acquisitions , spin-offs etc. Buffett could predict their time table , within reasonable error limits. An example of this group was sell-outs by oil producers to major integrated oil companies. This category produced stable earnings and whose performance was not related to Dow, hence they seemed to look good when Dow did not do well and vice-versa. This was the second largest category of the investment where Buffett would spread his assets into 5 to 10 of these companies. He was not afraid in borrowing money for investing in these assets because he could somewhat predict the stable earnings. In 1962 the partnership paid $75,000 in interest for a total debt of $1.5 million. These investments generated 10% to 20% return. Buffett was disciplined enough as to not borrow more than 25% of total partnership’s assets. Investments where the Partnership influenced the company’s operations These were investments where the Buffett partnership was the single largest shareholder and could influence the corporate actions. In short term if the prices declined then it worked in the partnership’s advantage as they could increase their holdings at a discount. These investments did not show much gains year over year , but finally yielded large gains when some major corporate action was taken. Following are some notable large investments belonging to this category. Commonwealth Trust co of Union city (Reference – letters to Buffett Partnership members 02/11/1959) The intrinsic value was $125 / share and Buffett bought it for $50 / share (becoming second largest shareholder of the company) However for good reasons, it paid no cash dividends at all despite earning $10 / share, which was largely responsible for a depressed price of about $50 / share. Commonwealth was 25.5% owned by a larger bank (Commonwealth had assets of about $50 million – about half the size of First National or U.S National in Omaha), which had desired a merger for many years. Such a merger was prevented for personal reasons, but there was evidence that this situation would not continue indefinitely. The trust had a winning combination of : 1. Very Strong defensive characteristics. 2. Good solid value building up at a satisfactory pace. 3. Evidence to the effect that eventually this value would be unlocked although it might be one year or 10 years. Over a period of a year or so, Buffett was successful in obtaining about 12% of the bank at a price averaging about $51/share. Obviously it was definitely to his advantage to have the stock remain dormant in price. His block of stock increased in value as its size grew, particularly after his partnership became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal. Commonwealth only had about 300 stockholders and probably averaged 2 trades /month. By late 1958 Buffett’s partnership had become the single largest shareholder of the company. He was able to sell his entire block for $80 / share , even though the market price was 20% lower. Thus in around 1 year Buffett made 60% return on this stock. Sanborn Map (Reference – letters to Buffett Partnership members 01/30/61): This was engaged in the publication and continuous revision of extremely difficult maps of all cities in the United States. The map showed minute street details like fire hydrants and composition of roof etc which was used by Underwriters of Insurance companies. The bulk of Sanborn’s customers were 30 Insurance companies. For 75 years the business operated in a very monopolistic way with steady profits with very little in sales expense. But by 1950 the company’s business became to deter because a competitive method of underwriting called “Carding” was introduced. The “after tax profit” fell from $500,000 per year to around $100,000 per year. During early 1930s the company began to accumulate an investment portfolio which blossomed to $2.5 million by 1950s. But market was not giving much weightage to it. In 1938 Dow Jones was at 100-120 range and Sanborn sold at $110 / share. In 1958 Dow Jones was 550 and Sanborn had declined to $45 / share. Yet during the same time the value of Sanborn’s portfolio had increased from $20/share to $65/share. Buffett was smart enough to recognize this and bought large chunk of shares from some disgruntled investors. Once he became the largest shareholder, he pursued the management to separate the map business and the investment portfolio and thus unlocking the hidden value of the investment portfolio. Dempster mill (Reference – letters to Buffett Partnership members 01/18/63): By 1962 Berkshire had bought 73% of Dempster mill manufacturing company. The company was engaged in manufacturing farm implements like water systems, water well supplies and jobbed plumbing lines. On an average Buffett paid $28 / share. The company’s adjusted book value was $35 / share. Initially Buffett tried to work with the management to more efficiently use the capital by planning to reduce the overhead, but these efforts did not bear any considerable result. A friend of Buffett recommended Harry Bottle, a ruthless corporate manager. On Apr-17-1962 Buffett met him and presented a deal which provided for rewards based on objectives, on Apr-23 he was in charge at Beatrice. Harry was like a magician who surpassed all of Buffett’s targets. Harry was instrumental in freeing a lot of capital that was tied to non-performing assets. This helped the company’s capital position and helped it to secure $1.25 million. The company’s overall valuation was $51 / share (This included $16 / share tied to manufacturing) BUFFETT'S FIRST MILLION By Jan-1 1963, the partnership’s net assets was $9,405,400. Buffett and his wife Susie together had a share of $1,377,400. Thus Buffett joined the millionaire’s club.