Insights

Investment Advice From Buffett & Munger

Whitney Tilson, Value Investor Insight 06.07.07, 6:00 PM ET

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The following is an excerpt of notes taken by Whitney Tilson, co-editor of

Value Investor Insight at Berkshire Hathaway's annual meeting in May 2007.

Warren Buffett: We favor businesses where we really think we know the

answer. If we think the business’ competitive position is shaky, we won’t try
to compensate with price. We want to buy a great business, defined as
having a high return on capital for a long period of time, where we think
management will treat us right. We like to buy at 40 cents on the dollar, but
will pay a lot closer to $1 on the dollar for a great business.

If we see someone who weighs 300 pounds or 320 pounds, it doesn’t matter--
we know they’re fat. We look for fat businesses.

We don’t get paid for the past, only the future [profitability of a business].
The past is only useful to give you insights into the future, but sometimes
there’s no insight. At times, we’ve been able to buy businesses at one-
quarter of what they’re worth, but we haven’t seen that recently [pause]
except South Korea.

Charles Munger: Margin of safety means getting more value than you’re
paying. There are many ways to get value. It’s high school algebra; if you
can’t do this, then don’t invest.

Circle of Competence and Margin of Safety

When you’re trying to determine intrinsic value and margin of safety, there’s
no one easy method that can simply be mechanically applied by a computer
that will make someone who pushes the buttons rich. You have to apply a lot
of models. I don’t think you can become a great investor rapidly, no more
than you can become a bone-tumor pathologist quickly.

Buffett: Let’s say you decide you want to buy a farm, and you make
calculations that you can make $70 an acre as the owner. How much will you
pay [per acre for that farm]? Do you assume agriculture will get better so you
can increase yields? Do you assume prices will go up? You might decide you
wanted a 7% return, so you’d pay $1,000 a acre. If it’s for sale at $800, you
buy, but if it’s at $1,200, you don’t.
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If you’re going to buy a farm, you’d say, "“I bought it to earn $X growing
soybeans." It wouldn’t be based on what you saw on TV or what a friend said.
It’s the same with stocks. Take out a yellow pad and say, "If I’m going to buy
GM at $30, it has 600 million shares, so I’m paying $18 billion," and answer
the question, why? If you can’t answer that, you’re not subjecting it to
business tests.

We have to understand the competitive position and dynamics of the

business and look out into the future. With some businesses, you can’t. The
math of investing was set out by Aesop in 600 B.C.: A bird in the hand is
worth two in the bush. We ask ourselves how certain we are about birds in
the bush. Are there really two? Might there be more? We simply choose which
bushes we want to buy from in the future.

The ability to generate cash and reinvest it is critical. It’s the ability to
generate cash that gives Berkshire value. We choose to retain it because [we
think we can reinvest each dollar to generate more than $1 of value].

If you were thinking about paying $900,000 or $1.3 million for a McDonald’s
stand, you’d think about things like whether people will keep eating
hamburgers and whether McDonald’s could change the franchise agreement.
You have to know what you’re doing and whether you’re within your circle of
competence.

Munger: We have no system for estimating the correct value of all

businesses. We put almost all in the "too hard" pile and sift through a few
easy ones.

Buffett: We know how to recognize and step over one-foot bars and
recognize and avoid seven-foot bars.

Advice on Becoming a Successful Investor

I think you should read everything you can. In my case, by the age of 10, I’d
read every book in the Omaha public library about investing, some twice. You
need to fill your mind with various competing thoughts and decide which
make sense. Then you have to jump in the water--take a small amount of
money and do it yourself. Investing on paper is like reading a romance novel
versus doing something else. [Laughter] You’ll soon find out whether you like
it. The earlier you start, the better.

At age 19, I read a book [ The Intelligent Investor by Benjamin Graham], and
what I’m doing today, at age 76, is running things through the same thought
process I learned from the book I read at 19.

I remain big on reading everything in sight. And when you get the opportunity
to meet someone like Lorimer Davidson (former CEO of GEICO), as I did, jump
at it. I probably learned more in those four hours than in almost any course in
college or business school.
Munger: Sandy Gottesman, a Berkshire director, runs a large, successful
investment firm. Notice his employment practices. When he interviews
someone, he asks, "What do you own and why do you own it?" If you’re not
interested enough to own something, then he’d tell you to find something
else to do.

Buffett: Charlie and I have made money in a lot of different ways, some of
which we didn't anticipate 30 to 40 years ago. You can’t have a defined road
map, but you can have a reservoir of thinking, looking at markets in different
places, different securities, etc. The key is that we knew what we didn’t know.
We just kept looking. We knew during the Long Term Capital Management
crisis that there would be a lot of opportunities, so we just had to read and
think eight to 10 hours a day. We needed a reservoir of experience. We won’t
spot every one, though--we’ve missed all kinds of things.

But you need something in the way you’re programmed so you don’t lose a
lot of money. Our best ideas haven’t done better than others’ best ideas, but
we’ve lost less. We’ve never gone two steps forward and then one step back--
maybe just a fraction of a step back.

Munger: And of course the place to look when you’re young is the inefficient
markets. You shouldn’t be trying to guess if one drug company is going to
have a better pipeline than another.

Buffett: You should do well in games with few other players. The RTC
[Resolution Trust Corporation; click here for more on this] was a great
example of a chance to make a lot of money. Here was a seller [government
bureaucrats] with hundreds of billions of dollars of real estate and no money
in the game, who wanted to wrap up quickly, while many buyers had no
money and had been burned.

There won’t be any scarcity of opportunity in your life, although there will be
times when you feel that way.

Ben Graham Still Beats The Market

John Reese, Validea Hot List 04.20.07, 12:00 PM ET

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Among the cognoscenti of value investing, Benjamin Graham is a revered

figure. The first superstar strategist on Wall Street, he is actually the father of
modern securities analysis and was Warren Buffett's teacher at Columbia
University. As regular readers of this column know, I believe you can be
successful by consistently following the strategies of Wall Street's best
investors, and Graham is the granddaddy of them all.
From steel to finance, several stocks appeal strongly to the strategies of
Buffett, Lynch, Graham and other superstar gurus.

Though he died in 1976, his books are still in print, and his investment
philosophy is still widely studied. Among those who follow my guru strategy
approach to investing, he is also held in high regard. Currently, out of the
dozen or so strategies I follow, the one that I base on Graham's writings
comes in No. 2 in terms of total return.

Since I've been tracking the guru strategies starting in July 2003, the Graham
strategy has provided a 177.2% return. That compares with a 46.8% return
from the S&P 500 during the same time period. Keep in mind that this is not
backdating or theorizing. This impressive return is based on nearly four years
of applying the Graham strategy's discipline to the market.

Graham is the classic value investor. He sought out companies that were
performing well and operated in basic businesses--nothing too esoteric
(hence his disciple Buffett's tendency to steer clear of technology and other
types of businesses that he says he doesn't understand). In addition, to
improve his chances of making money, Graham would buy stocks from such
companies only if they were trading at a discount to what he thought they
should be.

Make no mistake, the Graham strategy is a highly selective one, and some
investors and analysts argue that because The Intelligent Investor,
Graham's book on which I base the methodology, was published in 1949, the
exact approach is too rigorous and outdated. With a return that's nearly triple
that of the market over the last four years, I beg to differ.

The Graham strategy wants to see earnings per share grow at least 30% over
10 years. But it doesn't just look at the first and last year's EPS. It averages
the earnings of the first three years of the 10-year period and then averages
the last three years of that same 10-year period.

Likewise, when looking at the price-to-earnings ratio, Graham uses the

average EPS of the last three years, not just the most recent year. By using
the average EPS over three years and not just the common one year, Graham
cleverly overcomes the distortion when the EPS is unusually high, low or even
negative in one of the comparison years. This is particularly helpful with
cyclical companies.

Because of its superb record, and the strategy's ability to find deep value
stocks, I want to present a few ideas that the Graham screen recently
uncovered.

Jakks Pacific (nasdaq: JAKK - news - people ): This toy manufacturer has
a strong current ratio of 2.64 (meaning that it has a lot of liquid assets
relative to the size of its debt), has had consistent and hefty (404%) EPS
growth over the past 10 years, has a modest (13.10) price-to-earnings ratio
and a reasonable price-to-book ratio of 1.17. When multiplying the P/E by
price-to-book ratios, the number cannot exceed 22; in Jakks' case, it comes to
15.33. Very nice.

Encore Wire (nasdaq: WIRE - news - people ): A manufacturer of copper

electrical building wire and cable, Encore has an impressive current ratio of
9.98. The company's long-term debt is $99 million, less than a third of its net
current assets of $333.9 million. Over the past five years, EPS has
consistently been positive, and over the past 10 years, it has grown an
impressive 342.6%. The stock has a P/E of only 9.0 (using the three-year
average), while the P/B ratio is 1.78. Multiplying the P/E and P/B ratios comes
to 16, well below the 22 maximum allowed.

Posco (nyse: PKX - news - people ): According to Morningstar, South

Korea-based Posco is the third-largest steel maker in the world. It is a favorite
of the Graham strategy because its current ratio is 2.41, long-term debt is but
35% of net current assets, the P/E ratio is 2.4, the P/B is 1.69 and multiplying
the P/E with the P/B produces the remarkably low figure of 4.06.

Muellar Industries (nyse: MLI - news - people ): Muellar manufactures

metal and plastic products used in air conditioning, plumbing, heating,
machinery and automobiles. Its current ratio is an impressive 3.04, its 10-
year EPS growth has been 69.3%, EPS has been positive in each of the past
five years and its P/E ratio is 10.7, while its P/B ratio is 1.92. Multiplying the
P/E and P/B comes to 20.54, just below the 22 maximum allowed by the
strategy.

Novamerican Steel (nasdaq: TONS - news - people ): Canadian-based

Novamerican manufactures steel and aluminum. Its current ratio is a high
and impressive 3.36. Its long-term debt is only $2.5 million, while its net
current assets are $227.5 million--net current assets are a whopping 91 times
long-term debt. In addition, EPS has grown 363.9% during the past 10 years.
The P/E ratio is 12.83, while the P/B is 1.58. When combined, they come to
20.27.

These are five companies that are performing well financially, while having
stock prices that are modest, given the companies' performance. The Graham
strategy is itself performing well. I would say the prospects for all of these
companies' stocks appear quite good.

John P. Reese is founder and CEO of Validea.com and Validea Capital

Management. He is also co-author of The Market Gurus: Stock Investing
Strategies You Can Use From Wall Street's Best . Click here for more of
Reese's insights and analysis, and to learn about subscribing to the Validea
Hot List. At the time of publication, John Reese and his clients were long on
Jakks Pacific, Encore Wire, Posco and Muellar Industries.
Tech Stocks For Buffett And Zweig
John Reese, Validea Hot List 04.24.07, 4:25 PM ET

While both have amassed huge fortunes because of their incredibly

successful investing strategies, a trip to the homes of Warren Buffett and
Martin Zweig might lead you to believe that the two Wall Street greats have
little in common.

Buffett, whose net worth of $52 billion makes him the world's third-richest
man, still lives in the gray stucco house he bought nearly 50 years ago for
$31,500, according to Forbes, which says that the Omaha, Neb., home was
assessed at $700,000 in 2003. Zweig, meanwhile, reportedly lives in
Manhattan's most expensive apartment, a $70 million penthouse atop the
tony Pierre Hotel. The apartment includes the Pierre's original ballroom, which
is now a "grand salon" with 20-foot-high French doors overlooking the Big
Apple. Forbes ranks the home as the eighth-most expensive in the world.

While they have made quite different uses of their money, the principles that
helped Buffett and Zweig amass their respective fortunes are in many ways
quite similar.

Buffett, perhaps the most famous investor in the world, has built a reputation
for a conservative, long-term approach to stock purchasing. He targets
companies that have long histories of growth and hangs onto his holdings for
years, or even decades.

Zweig, whose Zweig Forecast newsletter was considered one of the best, if
not the best, investment manual during its 27-year run, is a growth investor
but has a serious conservative streak. He also has strict historical earnings
criteria and often holds onto stocks for years.

Because of their conservative, stringent approaches, Buffett and Zweig don't

often target the hot technology stocks, many of which gain attention because
of recent price jumps that are due to promising future prospects, not strong
long-term performance. So when I find tech stocks that score well using the
"guru strategies" that I base on the philosophies of Buffett and Zweig, I sit up
and take notice.

Currently, there are three tech stocks that have exhibited the type of long-
term earnings success that gets them approval from either my Buffett- or
Zweig-based strategies.

Total System Services (nyse: TSS - news - people ) is a Columbus, Ga.-

based company that provides electronic payment processing technology and
services to merchants, allowing customers to use credit, debit and other
types of cards. Total System, which has a market cap of $6.5 billion, gets
strong interest from my Buffett-based model, in part because of its history of
predictable, steadily increasing earnings. Its earnings per share have
increased in every year for the past decade, rising from 24 cents 10 years
ago to $1.26 last year.
As another part of his conservative approach, Buffett looks for companies
that have little debt, and my Buffett-based strategy targets companies whose
earnings would allow them to pay off their debt within two years if need be.
With debt of just $10 million and annual earnings of $256.1 million, Total
System is in a position where it could easily pay off its debt within two years,
which my Buffett-based model considers exceptional.

Buffett also likes companies that use retained earnings in a way that benefits
shareholders. The strategy that I base on his philosophy thus looks at how a
company's retained earnings over the past 10 years compare with its gain in
earnings per share over the same period. In the past decade, TSS has
experienced a $1.02 gain in EPS and a $5.22 gain in retained earnings,
meaning that management has proved it can earn shareholders a 19.5%
return on those retained earnings. My Buffett method considers that more
than acceptable.

Two Zweig-Type Choices

The strategy that I base on Zweig's writings currently has strong interest in
two tech stocks. The first I'll examine is FactSet Research Systems (nyse:
FDS - news - people ), which provides financial information on thousands of
companies around the world, allowing users to analyze company
fundamentals and compare stocks.

The Norwalk, Conn.-based FDS, which has a market cap of $3 billion, passes
several of my Zweig-based earnings tests. With long-term EPS growth of
19.88% per year, based on the average of the three-, four- and five-year EPS
growth rates, FactSet comes in above my Zweig method's 15% minimum. Its
EPS figures have increased from 78 cents to 98 cents to $1.15 to $1.43 to
$1.64 over the past five years, passing another of this method's earnings
tests.

Zweig doesn't just like earnings to be growing, however; he also

likes the rate of that growth to be increasing. FactSet's EPS growth rate
for the current quarter (compared with the same quarter last year) of 36.84%
easily exceeds its long-term EPS growth rate of 19.88% (based on the
average of the three-, four- and five-year figures), showing that earnings
growth is accelerating. In addition, this quarter's EPS growth rate exceeds
FactSet's average growth rate for the past three quarters (17.54%, when
compared with the same three quarters last year), meeting another of my
Zweig-based model's earnings acceleration criteria.

Moreover, while companies in the computer services industry have average

debt/equity ratios of almost 136%, FactSet has no debt, garnering high marks
from my Zweig-based strategy.

Another tech stock that gets high marks from my Zweig model is Quality
Systems (nasdaq: QSII - news - people ), an Irvine, Calif.-based company
that develops and provides information technology systems for medical and
dental offices. Like FactSet, Quality Systems has generated consistent
historical earnings growth and posted successive EPS figures over the last
five years (21 cents, 28 cents, 40 cents, 61 cents and 85 cents) that pass my
Zweig model's earnings persistence test.

In addition, Quality Systems' earnings growth in the current quarter--77.78%,

compared with the same quarter last year--easily surpasses its historical
earnings growth rate (43.18%, based on the average of the three-, four- and
five-year EPS figures) and its EPS growth rate for the previous three quarters
(46.55%, compared with the same three quarters last year), passing two of
my Zweig method's earnings acceleration tests.

My Zweig-based strategy also likes that Quality Systems, like FactSet, has no
debt.

The only blemish on Quality Systems' fundamentals, according to my Zweig

method, is that the company's revenue growth (27.25%) has not increased as
quickly as its historical earnings growth (43.18%). Zweig says that cost-
cutting measures can go only so far, and that continued earnings
growth must be driven by sales growth, so my model looks for stocks
that have a sales growth rate that is comparable to earnings growth.

But this sales growth rate shortcoming may be due more to Quality Systems'
extremely high earnings growth rate than to a sales problem. Its sales
increased 43.9% this quarter and 26.8% last quarter (compared with the
same respective quarters last year). Zweig likes stocks to have a greater
sales increase in the current quarter than the previous quarter,
showing sales acceleration. So while it failed the first Zweig sales-related
test, Quality Systems passes this one.

Jumping into the technology sector can be a risky proposition. Because of the
rapidly evolving nature of technology, many tech companies are relatively
new and don't have a lot of history to go on. And, as many investors found
out all too painfully a few years ago, speculation about new technologies or
products can wildly drive prices of stocks within the sector, skewing the
perception of how valuable some companies are.

Each of the three companies I've mentioned has a strong history of growth
and little or no debt, making them the kind of tech stocks that I think even
conservative-minded investors like Buffett or Zweig might appreciate. If
you're looking to add a few lower-risk tech stocks to your portfolio, you'd be
wise to give them a closer look.

John P. Reese is founder and CEO of Validea.com and Validea Capital

Management. He is also co-author of The Market Gurus: Stock Investing
Strategies You Can Use From Wall Street's Best.
Buffett Strategy Big On Retail
John Reese, Validea Hot List 05.17.07, 1:50 PM ET

A report from the National Federation of Retailers' Shop.org showed this

week that the online retail sales market is booming, forecasting an 18% jump
this year.

For the first time, computer-related products were not No. 1 on the list of top
online sales items. Instead, apparel took the top spot, a sign that online
buying has gone mainstream.

On the whole, however, the retail industry is far from booming. Last month's
retail sales were the lowest on record for April, according to The Associated
Press, which led, if only briefly, to the market's biggest dip in two months May
10. I thought that this weakness might create some buying opportunities in
the industry, so to find some good buys I ran a bunch of retailers through my
"Guru Strategy" computer models on Validea.com. Each quantitative guru-
based strategy is based on the philosophy of a different Wall Street great.

One of the interesting things I found was that, despite being one of my more
stringent models, the strategy that I base on the philosophy of the legendary
Warren Buffett spots more bullish opportunities in retail. Buffett, of course,
has been doing some major shopping of his own recently. On Tuesday, he
revealed Berkshire Hathaway's (nyse: BRKA - news - people )major stakes in
two railroads--Norfolk Southern (nyse: NSC - news - people ) and Union Pacific
(nyse: UNP - news - people )--as well as its $79.5 million stake in the nation's
largest health insurer, WellPoint (nyse: WLP - news - people ).

And Buffett's not done buying--he has said that Berkshire is now looking to
make an acquisition in the $40 billion to $60 billion neighborhood if he could
find the right company at the right price. I'm not going to suggest that any of
the retailers approved by my Buffett-based model will become that big buy.
(Most, in fact, are too small for the type of investment Buffett has suggested.)

Here are several strong retailers that I would consider "Buffett-type"

investments:

Walgreen (nyse: WAG - news - people ): This drugstore giant has been around
for more than 100 years, but its growth has increased exponentially over the
past two decades. It has opened more than 4,700 stores since the mid-1980s,
and it plans to reach the 7,000-store mark by 2010.

But Walgreen, which now has a market cap of $44.4 billion, hasn't just grown
physically; it's also had steady growth in earnings in the past decade, one of
the reasons it scores so well using my Buffett-based method. Buffett likes
companies that have a long history of strong, stable earnings, so my strategy
requires that a stock's earnings per share have increased in at least nine of
the past 10 years. Walgreen's EPS have increased every year for the past
decade, passing the test.
When I talk about "Buffett-type" stocks, I'm also talking about companies that
are conservatively financed, so my Buffett-based strategy requires that a
company could, based on its earnings, pay off its long-term debt within two
years. Walgreen doesn't need two years; in fact, it doesn't even need two
hours. The drugstore chain has no long-term debt, easily passing this test.

Another "Buffett" criterion is strong management. One way to measure this is

by checking out how management has used a company's retained earnings.
Walgreen's EPS have increased by $1.28 in the past 10 years, while its
retained earnings over that period total $8.25, showing that the company can
earn shareholders 15.5% annually on earnings it has kept. That falls into my
Buffett method's best-case range.

Sysco (nyse: SYY - news - people ): Sysco, which has a market cap of $20.6
billion, supplies food service providers with an array of products, ranging from
fryers to freezers to food itself. Though its EPS dropped from $1.47 to $1.34
last year, this is the only time its earnings have dipped in the past decade,
which is good enough to pass my Buffett-based earnings predictability test.

Sysco does have debt--$1.63 billion worth of it, to be exact--but its earnings
of $951.5 million are high enough that the company could pay off that debt in
two years, showing conservative financing.

One area in which Sysco has really excelled is in its return on equity. Buffett
sees ROE as a measure of whether a company has a "durable competitive
advantage" over its counterparts. He likes companies with ROEs greater than
15%, so my Buffett-based method sets that as a target both for average ROE
over the past 10 years and the past three years. Sysco's ROEs over the past
decade is 28.3%, while its average ROE over the past three years is 31.6%.
The Houston-based company is taking what it has and making it grow
significantly every year, a great sign.

TJX Cos. (nyse: TJX - news - people ): If you're looking to get some nice
clothes at good prices, you should check out discount retailers like T.J. Maxx,
Marshalls or Bob's Stores. If you're looking for a nice stock at a good price,
you should check out TJX, the parent company of all three of those discount
retailers. The Massachusetts-based firm, which has a market cap of $12.9
billion, has posted EPS gains every year for the past decade. It has $808
million in debt, but it could almost pay that off in a year based on its $792.2
earnings, showing good, conservative financing.

So far, all of the Buffett-based criteria we've looked at have been

quantitative; that is, they deal with the strength of a company's
fundamentals. But Buffett doesn't just buy companies that fit a certain
profile; he also makes sure that he's buying them at good prices. One way he
does this is by comparing a company's initial expected yield to the long-term
Treasury yield. (If it's not going to earn you more than a nice, safe T-bill, why
take the risk involved in a stock?)
When we take TJX's trailing 12-month EPS of $1.62 and its current price of
$28.37, we get an initial expected rate of return of 5.71%, exceeding the
current long-term Treasury yield (4.75%). Combined with TJX's historical EPS
growth (11.6%, based on the average of the three-, four- and five-year
figures), we see that the stock is a better choice than Treasury bills, which
Buffett sees as a good sign.

CDW (nasdaq: CDWC - news - people ): This Illinois-based tech firm sells
items made by such big brands as Apple (nasdaq: AAPL - news - people ), IBM
(nyse: IBM - news - people ), Sony (nyse: SNE - news - people ), Panasonic
and Adobe Systems (nasdaq: ADBE - news - people ), and provides support
services to its clients. It has a market cap of $6.2 billion and, like the other
stocks I've mentioned, has a stellar earnings history. Its EPS has dipped just
once in the past 10 years, rising from $0.59 to $3.30 during that time. What's
more, CDW has no debt.

CDW also gets high marks for management, as its EPS gain in the past
decade ($2.71) and total retained earnings over that period ($18.06) show
that management has earned shareholders a sterling 15% per year on
retained earnings. Its return on equity has also consistently exceeded this
model's 15% minimum, with a 10-year average ROE of 21.2% and a three-
year average ROE of 19.3%, indicating that the company has a durable
advantage over its competition.

Hibbett Sports (nasdaq: HIBB - news - people ): Buffett generally buys big
companies, both because they tend to have the kind of consistent earnings
he likes and because Berkshire Hathaway has got so big that it needs to
make large purchases to have any kind of impact. But that's not to say that
there aren't small-caps that meet my Buffett-based strategy, and Alabama-
based Hibbett, with a cap of $854 million, is one such company.

Despite its small size, Hibbett, which sells sports equipment and apparel, has
demonstrated remarkable earnings persistence over the past decade. Its EPS
have grown in each of the past 10 years, averaging a 25.6% gain over that
span. What's more, the company has no debt. That shows that, like the other
stocks I've mentioned, Hibbett is conservatively financed, part of the reason
my Buffett-based strategy likes it so much.

As I said earlier, I'm not saying that Buffett's impending "big buy" will come
out of this bunch. Nonetheless, all of these companies have strong positions
in their industries, consistent earnings streams and manageable debt, and
have shown they can get shareholders good returns, making them the type of
investments that Buffett has gravitated toward. They may not get added to
Buffett's holdings, but they are all stocks you should consider adding to your
own portfolio.

John P. Reese is founder and CEO of Validea.com and Validea Capital

Management. He is also co-author of The Market Gurus: Stock Investing
Strategies You Can Use From Wall Street's Best . Click here for more of
Reese's insights and analysis and to learn about subscribing to the Validea
Hot List.