Book Summary
Who is Jeremy C. Miller?
Jeremy C. Miller is an investment analyst for a leading New York-based mutual fund company. He has over fifteen years of financial industry experience, having served in various capacities across equity sales and research at several of the world’s largest investment banks.
PART I
Chapter 1: Orientation
Stock Market will at times go wild and irrational in offering a stock price in the short-term, but in the long run, the price of any stock will reflect the economic experience of a business. Buying a stock is same as buying a business; you claim fractional ownership of a business. If the market price of any business (stock) moves below intrinsic value for any extended period of time, market forces will eventually act to correct the undervaluation because, in the long-term, the market is efficient.
What's going to happen is simply too hard to predict, therefore, Buffet never tries to predict when a big drop in the market is going to come. Warren Buffett's views on macro variables play no part in investing decision. His main focus has always been whether the current price of a stock is lower than its intrinsic value or not.
Chapter 2: Compounding
Compounding is the process of continuously reinvesting gains such that each subsequent gain begins earning a return itself. Einstein is said to have called compound interest the eighth wonder of the world and said that “those who understand it, earn it, and those who don’t, pay it. Buffett was convinced by his mid-twenties that the power of compound interest was going to make him rich. On many occasions, he emphasized the importance of compound interest in long-term investment. In his letter in 1965, he gave an example of compound interest that a $100,000 invested for 20 years at the rate of 12% would turn into 1 million.
Chapter 3: Market Indexing: The Do-Nothing Rationale
Majority of the investors who invest on their own or through actively managed mutual fund under perform the market. One of the best investing strategies for investors who are not able to dedicate enough time is to invest in a low-cost index fund. It provides a better return than average market, it is cheap and easy to implement on your own. John Bogle founded the Vanguard 500 Index Fund in 1975 and created the first security that itself owned a slice of every company in S&P 500.
Chapter 4: Measuring Up: The Do-Nothings Versus the Do-Somethings
Two of the Buffet’s eight Ground Rules (# 4 and 5) focused on establishing the measurement ‘how’ and ‘how long’ in order to select the partners in the Buffett Partnership Limited (BPL). These two rules are so simple, unlike many investment managers, that they still work perfectly well for investors today. Rule # 4: Results must be measured relative to the Market’s (Dow Jones Industrial Average). Even though his own goal was to beat the market by at least 10 points (e.g. if market compounded by 7%, he would wish to compound by 17%). Rule # 5: Relative performance should be measured on at least a 3-5 trailing basis to be relevant but a 5-year test is even better.
Chapter 5: The Partnership: An Elegant Structure
Warren Buffett set a perfect example of a partnership structure that benefits both investors and money managers. The structure of Buffett Partnership Limited (BPL) was based on how Warren Buffett performed. He took a percentage of gains beyond certain threshold profit (25% of gains beyond 6%). This partnership turned out to be a win-win situation for two reasons: Warren Buffett had a stake in the partnership by investing his money and he would only make money when the returns would be more than 6%.
Mutual Funds and Hedge Funds charge a management fee as a fixed percentage of investor's assets ranging from .25% to 2% or more, per year. The fee is taken irrespective of their performance. And, in most cases, money managers don’t have any personal stake or any performance incentives. BPL is a great example of how to align manager incentives and investor objectives.
PART II
Chapter 6: Generals
Warren Buffett has adopted a diversity of investment styles meeting the needs of the time and the amount of money he wanted to invest. Being a disciple of Benjamin, Buffet initially cloned his deep value investment strategy in which he would find stocks trading at a steeply discounted price to their appraised intrinsic value using the private owner method - what a well-informed private owner would pay for the entire company (this method is widely known as net-net). Often they were tiny, obscure and off the radar companies trading below their liquidation value. These businesses were not necessarily good or high quality but they were cheap.
As the partnership grew and smaller companies become increasingly less investable, Buffett began investing in large companies that were too large for a single private owner to acquire but they that were still undervalued relative to where peer companies are trading. Charlie Munger convinced Warren Buffet to change his ground rule from ‘buying fair businesses at wonderful price’ to ‘buying wonderful businesses at fair price’.
Chapter 7: Workouts
The workout is another investing method Warren Buffet applied especially in early years of BPL investing. This financial practice is called arbitrage - a practice that follows a straightforward formula: Something is bought at X, a value is added or risk assumed, and then a sale is made at X plus a profit.
In a traditional risk-free arbitrage, profits are made when two identical or near identical items trade at different prices in different places at the same time. For instance, when a company’s stock (identical in every way) trades for a lower price in New York than in London, equity arbitrageurs can buy stock in one city and sell it in another and capture the spread.
But, Buffett called workouts for his merger arbitrage investment. When a company announces its intention to purchase another public company, the selling company’s stock typically trades up to a level that’s close, but not all the way to the announced price. That’s where the opportunities lie. Buffet aimed to arbitrage transactions where the spread was sufficiently wide and the probability of the deal actually closing was high.
Chapter 8: Controls
Controls strategy focuses on valuing business assets and taking a large position so as to either influence or force decision making. Buffett executed many controls transactions throughout the BPL. Unless Buffet started with a very large position in the company his control position started from Generals category.
In his letters, he taught us through many examples that taking a control position means being in the business than investing in a business. ‘The dominant factors affecting the control valuations are earning power (past and prospective) and asset values. They are not necessarily good business but their assets’ market value less all liabilities exceeds the market price of the stocks. The art in the controls strategy is to be able to estimate the worth of assets. The balance sheet doesn't give a true picture as it records the cost, not the market value. Depending on the quality of the business, assets’ current market value could be more or less than the cost of purchase.
In some control position of companies like Dempster Mills and Sanborn Map Company Buffett took a confrontational position to increase the value of shareholder value. When you are a minority you are at the mercy of the existing management and the board of directors. One of the strategies for investors could be who can't take a large position is to invest in generals where other well-known and proven investors are doing the work to improve management decision-making and shareholders’ value.
Chapter 9: Dempster Diving: The Asset Conversion Play
Dempster was Buffett’s first experience jumping into the management of a Control with both feet and by giving a complete account of his investment in Dempster Mills in his partnership letters, he taught us many lessons on valuing the assets of a company. It perfectly captures his early investing process and illuminates how he implemented Graham quantitative style of investment.
The first lesson is to be extremely conservative in valuing the assets so that even a short period of holding will bring adequate returns. Graham set the basis of this method perfectly and advised, as a general rule of thumb, ascribing 100 cents on the dollar to cash, 80 cents on the dollar to receivables, 67 cents on the dollar for inventory (with a wide range depending on the business), and 15 cents on the dollar for fixed assets. In the case of Dempster, the value of their assets, less all liabilities, far exceeded the market price of the stocks - it was trading at a momentous discount.
Not long after his purchase, Buffet joined the company’s board of directors, and he kept buying the stock for the next five years. By 1961, he owned 70% of the company. Dempster accounted for roughly 20% of BPL’s total assets at year-end. In 1962, Buffett faced a tricky situation of high inventories and rising too fast. He tried to work with existing management but finally had to throw them out as inventories continued to build. The company’s bank was worried and threatening to recover its money. On the recommendation of Charlie Munger, Buffett met an operating man, Harry Bottle, and hired him on the spot. Harry did an outstanding job in reducing the inventories from $4 million to $1 million, alleviating the concerns of the bank, cut administrative and selling expenses in half and closed five unprofitable branches.
Through running the Dempsters, Buffett taught a second but very important lesson that, operationally, a business can be improved in only three ways: 1. Increase the level of sales 2. Reduce costs as a percentage of sales 3. Reduce assets as a percentage of sales
Chapter 10: Conservative Versus Conventional
One of the reasons Buffet has been hugely successful is because he never followed the crowd. He believes that successful investing requires you to do your own thinking and train yourself to be comfortable going against the crowd. In investment, you need to be hubris enough to think you can have insights that are superior to the collective wisdom of the market, humility enough to know the limits of your abilities and to be willing to change course when errors are recognized.
In his letter in 1965, he said:
“Truly conservative actions arise from intelligent hypotheses, correct facts, and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we drive comfort if they don’t.”
One other factor that made Buffet richer than his peers is his focus on the concentrated portfolio. In 1965, he introduced rule # 6 that the partnership can invest up to 40% of its net assets if an opportunity arises. There is nothing wrong with buying 50 or more companies if they can generate the same amount of profit, but it is virtually impossible. A few companies with a rational approach will lead to fortunes. He recommends comparing a new idea to the existing investments, if your idea of investing in the 9th company is not better than your first eight ideas, stick to the first eight.
Chapter 11: Taxes
Investors holding stocks for long-term benefits from the Deferred Tax Liabilities (DTLs). Investors who buy and sell every year gets taxed on capital gains every year, whereas investors who hold for longer gets taxed once at the end. The $10,000 invested for 30 years will compound at an extra 3.55% and 2.5 times better than an annual trader whose gains are taxed annually, there is no deferral of tax, and thus no benefit. However, holding for long-term should only be considered when your money is invested in good businesses.
Buffet teaches investors to assess the value of their holdings as if they have already been liquidated, meaning that your net worth is the market value of your holdings less the tax payable upon sale. Think of tax as a government loan and that has to be repaid upon sale of holdings.
Chapter 12: Size versus Performance
When the size of BPL was small it was easier for Warren Buffett to invest in companies regardless of size. However, as the partnership grew, opportunities became too small for the size of capital Buffett would want to invest. There are clear advantages to investing modest amounts of capital. Tiny, obscure and under-followed companies tend to be least efficiently priced and offer the most fertile ground for opportunities.
Chapter 13: : Go-Go or No-Go
The market goes through cycles and sometimes a speculation and bull market cycle could be longer than one could think. When the market is at its peak, all speculators’ fund becomes a go-go fund as it tends to make lots of money in the short term. In his letters in 1967 and 1968, Warren Buffett mentioned several times that he is running out of quantity and quality of ideas as almost all the companies were trading at above their intrinsic value. Fund managers with their high speculation took the Dow to a new level where Buffet simply could not find enough good ideas to invest and thus decided to close the partnership.
Chapter 14: Parting Wisdom
In 1969, Buffett decided to close the BPL for two reasons: he thought he didn't have enough quality ideas for future investment and he didn’t want the pressure of beating market by some percentage points all the time. Buffet went about winding up the partnership in a unique way with a genuine care shown for his partners. He not only recommended an equity manager who he thought was able and is of high integrity, but he also offered his advice on bonds partner can buy if they decide to invest themselves. In addition, he wrote a brief manual for partners who want to invest in bonds themselves.
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