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BUFFETT INVESTMENT
METHODOLOGY
WBW: Chapters 1-3 and 10 and 12
WBP: Chapters 1-4
1
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Focus Investing
Modern Portfolio Theory (MPT) encouragesdiversification to reduce risk.
Buffett believes that the benefits ofdiversification are more than offset by theproblems associated with managing largenumbers of securities
Buffett prefers to make large bets on a smallnumber of companies in his circle of
competence Buffett has dubbed this approach Focus
Investing
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Wells Fargo 2007-2012
Finance.yahoo.com
WFC
Historical prices Monthly data
Jan 1, 2007 Dec 31, 2012
3
Also available on the Blackboard page
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Wells Fargo
4
1. Sort the data (oldest to newest, A to Z)2. Use the adjusted close column3. Make a chart of the adjusted close from Jan 2007 Feb 2009
i. Add the monthly volume to this graphii. Add a secondary axis
4. Calculate the monthly % return for each month 2007-2012
5. Calculate the value of $100,000 invested at the end of January 2009each month to December 2012
6. Make a chart of your values in part (5)7. Calculate your compound monthly return and annualize this number
=
1
= 1 +
= 1 + 2
1 =
1
Use the COUNT function
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Charlie Munger
5
Charlie Munger: Lessons From an Investing Giant
August 30, 2013, page B1
Summary: In the first quarter of 2009, Charlie Munger invested 71%of the cash of a small publishing unit he chairs in bank stocks.Sources say the largest positions were in Wells Fargo and USBancorp.
StockAverage annual Return
1Q2009 end 2012
Wells Fargo 18.57%
US Bancorp ?
Homework: Repeat the WFC example with US Bancorp (USB) data from Jan 2007-Dec
2012. Find the average monthly return and annualize the return. YOU MUST USE THE
COUNT function!!!! Do this in groups of 2 or 3.
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Lessons
What you can learn from Charlie:
Individual investors can be patient
You can sit on cash, professional money managers
cannot
You can be brave and make bold moves
Especially if you are young
How old is Charlie?
6
Charlies advice: Sit on your ass regardless of what the investment crowd is
doing until a good investment finally materializes.
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Lessons
How do you know when a good investment is
available?
7
Most money managers spend their days in meetings, riffling through emails,
staring at stock-quote machines with financial television flickering in the
background, while they obsess about beating the market.
Mr. Munger and Mr. Buffett, on the other hand, sit in a quiet room and read
and think and talk to people on the phone.
By organizing their lives to tune out distractions and make fewer
decisionsMr. Munger and Mr. Buffett have tilted their odds toward making
better decisions.
From the WSJ article:
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Educational Influences on Buffett
Benjamin Graham Partner in brokerage firmof Newburger, Henderson & Loeb by thetime he was 25 he was making an annual
salary of $600,000 (in 1919). Ruined in the 1929 crash taught night
classes in finance at Columbia and (with DavidDodd, a finance professor at Columbia), wroteSecurity Analysis (1934) and The IntelligentInvestor(1949)
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Benjamin Graham
Introduced Buffett to the concept of Margin ofsafety
Margin of safety is the difference between the
intrinsic value of a company and the companysprice.
Suggested buying stocks selling for less than 2/3of net asset value. (p. 15 WBW)
Stock price should be less than net current assets
Focus on low-P/E stocks
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Benjamin Graham
Approach focused on stocks deeply out-of-
favor with the market.
Graham felt that market frequently mispriced
stocks by overreacting to bad news.
Early use of the concept of reversion to the
mean
Focused on statistics and bargain stocks little
interest in management.
10
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Benjamin Grahams Stock Selection
Rules for Defensive Investors
Adequate size not less than $100 million of annual sales for
industrial companies and $50 million of assets for public utilities
(1970)
Strong Financial Condition 2:1 current ratio and long term debt
< working capital Positive earnings for the common stock in each of the past ten
years.
Dividend payments in each of last 20 years.
Minimum increase of at least 1/3 in per-share earnings in the past10 years, using 3 year averages at the beginning and the end.
Price
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Excel Exercise
12
BEN GRAHAM DEFINSIVE INVESTING WORKSHEET
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Philip Fisher
Started Fisher & Company in 1931 after graduating from
Stanfords Graduate School of Business Administration.
Suggested investing in firms with above-average potential
and highly capable management.
Looked at profit margins and ability to grow without
external financing (as external financing would dilute
existing stockholders ownership).
Focus on integrity of management, depth of managementand relationship between management and employees.
Portfolios included fewer than 10 companies
Extensive interviews with companies and competitors.
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John Burr Williams
PhD Dissertation at Harvard was The Theory
of Investment Value introduced the concept
of the dividend discount model.
Buffett discounts owners earnings instead of
dividends, and uses the 10-year government
bond rate as the interest rate (or if interest
rates are very low, the average cumulativereturn of the overall stock market).
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Charlie Munger
Grew up in Omaha
Had a successful law practice in Southern Californiaand also ran an investment partnership.
Bought shares of Blue Chip Stamps and eventuallybecame chairman of its board. Berkshire and Blue ChipStamps merged in 1978 and he became Berkshires vicechairman. Now also chairman of Wesco Financial (80%owned by Berkshire).
Believes in paying a fair price for quality companies. Itis far better to buy a wonderful company at a fair pricethan a fair company at a wonderful price.
15
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Berkshire as an Insurance Company
Read Chapter 3 on your own it discusses
how Berkshires insurance business provides
that cash that funds Berkshires investments.
($44.2 billion in 2003).
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Focus Investing (Cont.)
Modern Portfolio Theory (MPT) stressesdiversification. Harry Markowitz (1952) efficient frontier and risk-
return tradeoff and concept of covariance.
Bill Sharpe (1963) concept of market risk (beta) Fama (1963) concept of efficient market
Buffett does not believe that investors always
behave rationally (an assumption of MPT), andthus doesnt believe that the market is alwaysefficient.
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Buffett on MPT
If prices are not always rational, measuring risk relative to themarket may not be meaningful.
Diversification reduces bad outcomes, but also reduces the chanceof good outcomes thus insuring that you will get averageoutcomes with less variability.
To beat the market, you need to be willing to accept morevolatility.
To achieve the maximum benefits from diversification, you mustinvest in lots of companies. It is likely that you will have to investoutside of your circle of competence and that you will not be ableto fully understand and analyze each investment.
Uses margin of safety concept to reduce risk, not calculations ofbeta and standard deviation.
Makes big bets on high probability events instead of pursuingdiversification.
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Buffett on MPT
Read the first part of Chapter 3 (WBP) on your
own.
Discusses results of successful focus investors
Bill Ruane (Sequoia Fund), John Maynard
Keynes, Charlie Munger and Lou Simpson
(GEICO).
Summarizes Buffett speech on efficient
markets in 1984 at Columbia University.
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Focus Investing Statistics
Look at WBP p. 54-62
Randomly constructed portfolios of different
sizes.
Focus portfolios beat the market but had
much higher volatility.
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