The Three "Bedrock" Ideas Behind Warren Buffett's Billions

In his European tour in May 2008, Warren Buffett was asked to name the most important lesson he learned from his mentor, Benjamin Graham.

Instead he listed three, using just 85 seconds to deftly describe the trio of "bedrock" ideas that have helped make him the world's richest man.

It all comes from this ....

Warren Buffett: The three most important lessons I learned were all from the same book, The Intelligent Investor. It was written first by (Benjamin) Graham in 1949. They appear in chapters 8 and chapters 20.

The first is, to look at stocks as pieces of businesses, not as little items on a chart that move around, not as ticker symbols, not as something that might split next week or next month or something of the sort. But, rather, to look at the business, value the business, divide by the shares outstanding, and decide whether you really want to own a piece of that business at that price.

The second one was his commentary about your attitude toward the stock market. That it is there to serve you rather than to instruct you, and he used the famous Mr. Market example of that. That attitude is fundamental to making money in stocks over time.

And the final item he talked about was margin of safety. When you buy a stock that you think is worth 10 dollars, you don't pay $9.95 for it, because you can't be that precise in estimating its value. So you leave a considerable margin of safety for both what you don't understand and for the vagaries of the future.

And those three ideas, which I learned when I was 19 years old, have been the bedrock of everything I've done since.

Source: http://www.cnbc.com/id/24839084/

Consistently good companies

From The Edge's 2007 Shareholder Value Creation Award pullout, there is a page which found useful. It's the page where it shows companies that are consistently appearing every year in the KPMG Shareholder Value Creation award since the past 6 years. Here's the page:

Below is the companies in alphabetical order:

I believe these companies are classified as "Good Companies". However, are they also a good stock (or a good investment) ?

Let's take for example British American Tobacco Malaysia Bhd (BAT), who is the No 1 in Shareholder Value Creation for 6 consecutive years. Looking at the table above, a person might wrongly conclude that BAT would be the best performing stock for its shareholders. But the truth is far from it. This is because a good company would only be a good stock (or a good investment) if the purchase price is a good price.

Continuing with BAT, in the year 2007, the company makes an Operating Profit of RM 1.049 Billion (before tax). If we adjust it for 27% tax, we'll get Net Operating Profit After Tax (NOPAT) of RM 766 Million.

To generate the profit above, the company uses its assets, which is called "Invested Capital". Invested Capital comes from 3 sources:
1) Total Interest bearing Debt, and
2) Deferred tax liabilities (some might exclude this, but KPMG includes it to calculate Invested Capital), and
3) Total Equity.

For the KPMG Shareholder Value Award, KPMG uses Average of beginning and end of the year's number for the 3 numbers above.

In year 2007, the Average for the sources of Invested Capital for BAT is as below:
(1) Total Interest bearing Debt = RM 725 Million,
(2) Deferred tax liabilities = RM 57 Million,
(3) Total Equity = RM 449 Million

Thus, the total Invested Capital for BAT in year 2oo7 is RM 1.231 Billion.

For a company to generate a NOPAT of RM 766 Million from Invested Capital of RM 1.231 Billion would mean the company earns 62.2% Return on Invested Capital (ROIC). This is anexcellent figure, especially when BAT has been able to maintain at ROIC at that high level for so many years.

Since BAT have 285.53 Million shares outstanding, the Average Equity per share would be RM 1.57 (derived from (3) Total Equity of RM 449 Million divide by 285.53 Million shares outstanding).

Now, are you buying BAT at RM 1.57 per share? If you do, then the return from the business would reflects a good return on your money as well. However, BAT's stock price is traded around RM 40 per share, which is 25.4 times the book value.

I believe at current price of BAT, the market have already fully valued BAT's performance to the stock price, and thus, a person who invested in BAT (which is a good company) might not be obtaining good results.

Summary: A good company might not be a good investment if the price paid is too high!


p/s: Some people argues that we should use the market's Equity price rather than the book value's Equity for the (3) Total Equity. Had we use the market's Equity price of RM 40 per share, the (3) Total Equity would be RM 11.4212 Billion (instead of just RM 449 Million). Then, the total Invested Capital would be RM 12,203.2 Billion, and the ROIC would just be 6.3% (which is just a moderate number).

Comments?