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Contents

Introduction: What Investors Can Learn from Warren Buffettvii
1It’s Easy to Invest like Warren Buffett1
2The Achievement of Warren Buffett9
3Buffett: A Life in the Stock Market17
4The In?uence of Benjamin Graham23
5The In?uence of Philip Fisher33
6How Value and Growth Investing Differ45
7Buffett’s 12 Investing Principles53
8Don’t Gamble55
9Buy Screaming Bargains61
10Buy What You Know69
11Do Your Homework73
12Be a Contrarian77
13Buy Wonderful Companies83
v14Hire Good People91
15Be an Investor, Not a Gunslinger97
16Be Businesslike115
17Admit Your Mistakes and Learn from Them121
18Avoid Common Mistakes127
19Don’t Overdiversify135
20Quick Ways to Find Stocks That Buffett Might Buy141
21William J. Ruane of Sequoia145
22Robert Hagstrom of Legg Mason Focus Trust153
23Louis A. Simpson of GEICO157
24Christopher Browne of Tweedy, Browne161
25Martin J. Whitman of the Third Avenue Funds171
26Walter Schloss of Walter & Edwin Schloss Associates177
27Robert Torray of the Torray Fund185
28Edwin D. Walczak of Vontobel U.S. Value197
29James Gipson of the Clipper Fund205
30Michael Price of the Mutual Series Fund209
31A Variety of Other Value Investors221
32Putting Everything Together237
Appendix 1Wanted: Cheap, Good Companies243
Appendix 2Berkshire Hathaway’s Subsidiaries (2000)245
Appendix 3Quotations from the Chairman246
Appendix 4“65 Years on Wall Street”255
Appendix 5Martin Whitman on Value Versus Growth265
Appendix 6A Weekend with the Wizard of Omaha: April 2001268
Appendix 7“If You Own a Good Stock, Sit on It.”—Phil Carret274
Glossary279
Index283
vi
CONTENTSIntroduction:
What Investors
Can Learn from
Warren Buffett
B
erkshire Hathaway’s stock has risen nearly 27 percent a year for

the past 36 years. For its consistency and pro?

tability, this com-

pany, managed by Warren E. Buffett of Omaha, has been amazing.
If you asked Buffett how you, as an individual investor, could go
about imitating his spectacularly successful investment strategy, his

answer would be: buy shares of Berkshire Hathaway.

He happens to

be an unusually sensible person, and that is clearly the best answer.
But if you buy or intend to buy other stocks on your own, either
one-at-a-time or through a managed mutual fund, there is much that
you can learn by studying Buffett’s tactics.
Why not just do the obvious and put all your money into Berkshire

Hathaway stock?

One reason: It’s mainly an insurance holding com-

pany—Buffett is an authority on insurance. Because of this, the
stock has virtually no exposure to many areas of the stock market,
such as technology and health care. A second reason: Berkshire has
become so enormous that its future performance is handicapped,
much like the odds-on favorite in a horse race being forced to carry
extra weights.
In short, you might do better on your own. First, because you have
a smaller, more nimble portfolio. And, second, because you might
shoot out the lights by overweighting stocks in whatever ?eld you’re
viiparticularly knowledgeable about—health care, technology, bank-
ing, whatever. Buffett refers to this as staying within your “circle of
competence.” (There’s nothing wrong, of course, with your also buy-
ing Berkshire stock. I have. The Sequoia Fund, run by friends of Buf-
fett’s, has one-third of its assets in Berkshire.)
While the average investor can learn a thing or two from the mas-
ter, he or she simply cannot duplicate Buffett’s future or past invest-
ment performance. One obvious reason: Buffett has the money to
buy entire companies outright, not just a small piece of a company.
He also buys preferred stocks, engages in arbitrage (when two com-
panies are merging, Buffett may buy the shares of one, sell the
shares of the other), and buys bonds and precious metals. He’s also
on the board of directors of a few companies Berkshire has invested
in. Perhaps the most dif?cult thing for individuals to duplicate is
Buffett’s small army of sophisticated investors around the country
who fall all over themselves to provide him with “scuttlebutt” about
any company he’s thinking of buying. Also, Buffett has the word out
to family-owned businesses: “I’ll buy your company and let you keep
running it” (another thing individuals can’t duplicate).
Let’s not forget, too, that Buffett also happens to be extraordinar-
ily bright, a whiz at math, and to have spent his life almost monoma-
niacally studying businesses and balance sheets. What’s more, he
has learned from some of the most original and audacious invest-
ment minds of our time, most notably Benjamin Graham.
Still, while it’s true that trying to emulate Pete Sampras or the
Williams sisters does not guarantee that you will wind up in Wimble-
don, you could very likely bene?t from any of the pointers they
might give—or from studying what it is they do to win tennis
matches.
Buffett has often said that it’s easy to emulate what he does, and
that what he does is very straightforward. He buys wonderful busi-
nesses run by capable, shareholder-friendly people, especially when
these businesses are in temporary trouble and the price is right. And
then he just hangs on.
There is, in fact, a whole library of books out there about Buffett
and his investment strategies. There are Berkshire web sites, Inter-
net discussion groups, and annual meetings that are beginning to re-
semble revival meetings. There is also a Buffett “workbook” that
helps people invest like Warren Buffett. It even includes quizzes.
This book isn’t written for the Chartered Financial Analyst or the
sophisticated investor (readers familiar with Graham and Dodd’s Se-
curity Analysis). It is for ordinary investors who know that they
could do a lot better if they knew a little more. And the truth is,
viii
INTRODUCTIONmuch of Buffett’s investment strategy is perfectly suited for the
everyday investor. His advice, which he has been generous in shar-
ing, is simple and almost sure?re.
Buffett buys only what he considers to be almost sure things—
stocks of companies so powerful, so unassailable, that they will still
dominate their industries ten years hence. He con?nes his choices to
stocks in industries that he is thoroughly familiar with. He will seek
out every last bit of information he can get, whether it’s a company’s
return on equity or the fact that the CEO is a miser who takes after
Ebenezer Scrooge himself. He scrutinizes his occasional mistakes,
quickly undoes them, and tries to learn lessons from the experience.
While he is loyal to the management and employees of companies he
buys, he is ?rst and foremost loyal to his investors. To Warren Buf-
fett, the foulest four-letter word is: r-i-s-k.
Beyond that, he avoids making the mistakes ordinary investors
make: buying the most glamorous stocks when they’re at the peak of
their popularity; selling whatever temporarily falls out of favor and
thus following the crowd (in or out the door); attempting to demon-
strate versatility by buying all manner of stocks in different indus-
tries; being seduced by exciting stories with no solid numbers to
back them up; and tenaciously holding onto his losers while short-
sightedly nailing down the pro?ts on his winners by selling.
In short, as Buffett has modestly confessed, the essential reason
for his success is that he has invested very sensibly and very ratio-
nally.
Another way of putting it: Buffet invests as if his life depended on
it.
A word of warning: Not all of Buffett’s strategies should necessar-
ily be imitated by the general investing public, in particular Buffett’s
penchant for buying only a relatively few stocks. A concentrated
portfolio, in lesser hands, can be a time bomb.
There are some things that geniuses can (and should) do that
lesser mortals should be wary of; there’s a law for the lion and a law
for the lamb. Ted Williams, the great baseball slugger, never tried to
bunt his way onto ?rst base, even during the days of the “Williams
Shift,” when players on the opposing team moved far over to the
right side of the ?eld to catch balls that Williams normally whacked
down that way. He wasn’t being paid to bunt toward third base and
wind up with a mere single, much the way Warren Buffett isn’t ex-
pected to do just okay. But you and I, not being quite in the same
class as those two, should be perfectly content with getting on base
consistently using such unimpressive techniques as bunt singles.
No doubt, overdiversi?cation—owning a truckload of different se-
INTRODUCTION ixcurities—is something that gifted investors should steer clear of. But
underdiversi?cation, owning just a few securities, is something that
ungifted investors (in whose ranks I happily serve) should also avoid
like the plague.
In 1996 there appeared a short, charming book with a cute title:
Invest Like Warren Buffett, Live Like Jimmy Buffett: A Money
Manual for Those Who Haven’t Won the Lottery (Secaucus, NJ:
Carol Publishing Group, 1996). The author is a Certi?ed Financial
Planner, Luki Vail.
The text talks about the blessings of an investor’s owning a diver-
si?ed portfolio, not a concentrated portfolio. Writes the author, “Di-
versi?cation of your investment dollars along with appropriate time
strategies are your best tactics to protect you against such things as
stock market crashes.” (“Time strategies” means suiting your portfo-
lio to your needs. If you think you’ll need your money in fewer than
?ve years, go easy on stocks.)
Why buy mutual funds? “Here is your chance to own stocks in 50
to 75 companies.”
“Generally, stay away from individual stocks until you have about
$250,000 to invest; then you can have a well-diversi?ed portfolio, like
your own personal mutual fund. That way when a stock takes a nose
dive on you, it will only have a small position in a very large portfo-
lio, and you will take only a small loss, which could possibly be off-
set by the gain of some other stock.”
In brief, she is recommending that readers of her book not swing
for the seats but bunt for singles. That’s no doubt sensible counsel
for her readers, but it is not the Warren Buffett way.
I might offer a compromise suggestion: The ordinary investor, the
lesser investor, might have a core portfolio of large-company index
funds composing 50 percent or more of the entire stock portfolio.
(Buffett has recommended that tactic for most investors.) And out-
side the core portfolio, the lesser investor might swing for the seats
by imitating the strategy of the man generally acknowledged to be
the greatest investor of our time.
Warren Boroson
Glen Rock, N.J.
x INTRODUCTIONCHAPTER 1
It’s Easy to Invest
like Warren Buffett
B
uying shares of Berkshire Hathaway is the easiest way to invest
like Warren Buffett. While the A shares cost around $70,000 apiece
as of this writing, the B shares sell for only around $2,300 each—
roughly 1
/30 of the A shares. The B shares do have their disadvan-
tages. For example, holders have less in the way of voting rights and
aren’t entitled to indicate where Berkshire charitable contributions
go. (Berkshire is unusual in allowing shareholders to recommend
how Berkshire’s charity money should be allocated.) And while you
can convert A shares into B, it doesn’t work the other way around.
Which to buy? Berkshire is nothing if not shareholder friendly,
and Buffett has given this advice: Buy the A shares, if you can af-
ford them, unless the B shares are trading cheaply. “In my opinion,
most of the time the demand for B will be such that it will trade at
about 1
/30 of the price of the A. However, from time to time, a differ-
ent supply–demand situation will prevail and the B will sell at some
discount. In my opinion, again, when the B is at a discount of more
than, say, 2 percent, it offers a better buy than A. When the two of
them are at parity, however, anyone wishing to buy 30 or more B
should consider buying A instead.”
1An investor might dollar-cost-average into Berkshire’s B shares us-
ing a discount broker. So, for example, in order to build a $13,200 po-
sition, he or she might buy two shares six times a year. Or, if the
buyer is less patient, two shares for three straight months.
It is also a good idea to check whether two leading newsletters,
The Value Line Investment Survey and Standard & Poor’s “The Out-
look,” give the stock a decent rating at the time of purchase, and per-
haps either wait a bit or buy energetically depending on their views.
(Hardly any other analysts cover Berkshire.) As of this writing, Value
Line rated Berkshire, at $70,000 a share, average; “The Outlook”—
whose Berkshire analyst, David Braverman, is probably the very
best—above average.
Another guide: Consider whether the stock is closer to its yearly
high or low. Buying Berkshire low is certainly appropriate for some-
one intending to be a follower of Warren Buffett’s value-oriented in-
vestment strategy.
Buying Individual Stocks
Another practical possibility for Buffett followers is to buy the pub-
licly traded stocks that Berkshire owns—like Coca-Cola, Gillette,
H&R Block, and General Dynamics. (Berkshire is also the sole
owner of various companies, like See’s Candy and GEICO, the insur-
ance company, but these companies are not publicly traded.) Be-
cause of Buffett’s history of purchasing reasonably priced stocks,
these stocks should still be worth buying.
A danger, of course, is that Berkshire may have begun unloading
those stocks, the way it began quietly bailing out of Disney in 2000,
as you are just beginning to purchase them. Another danger is that
your portfolio will be askew: You will have more exposure to certain
stocks and industries than Berkshire itself has. As a result, your
portfolio might be a riskier version of Berkshire.
You can balance out your Buffett-like portfolio with stocks from
the holdings of mutual funds that invest roughly the way Buffett
does, such as Sequoia, Tweedy, Browne Global Value and American
Value, Legg Mason Focus Trust (omitting from the last any technol-
ogy stocks, which Buffett tends to avoid), Third Avenue Value, Clip-
per, Longleaf Partners, Torray, and Vontobel U.S. Value. You can
examine a list of these funds’ recent holdings either by going to their
web sites or by consulting Morningstar Mutual Funds, a newsletter
to which most large libraries subscribe. The list of holdings will be
2 IT’S EASY TO INVEST LIKE WARREN BUFFETTsomewhat outdated, but, again, most of these value stocks should
remain reasonably priced.
You might also balance your portfolio by concentrating on stocks
in industries outside the ones you already have covered in your Buf-
fett-like portfolio, along with foreign stocks, which Buffett also
tends to avoid. For suggestions of foreign stocks to buy, check those
in the portfolio of Tweedy, Browne Global Value.
For U.S. stocks, I would single out health-care stocks because
Berkshire has tended to ignore this entire industry, perhaps because
the stocks have almost always been high-priced or because they are
outside Buffett’s “circle of competence.”
You can also balance out your Buffett-like portfolio with stocks
chosen from the list compiled at Quicken.com by Robert
Hagstrom. He derives this list using his criteria for picking Buffett-
type stocks, Hagstrom being an authority on Buffett’s strategy.
(See Chapter 20.)
For more on Sequoia, see Chapter 21; for Legg Mason Value Trust,
Chapter 22; for Tweedy, Browne, Chapter 24; for Third Avenue
Value, Chapter 25; for Torray, Chapter 27; for Vontobel, Chapter 28;
and for Clipper, Chapter 29.
Buying Buffett-like Mutual Funds
Instead of buying individual stocks, you could buy one or more Buf-
fett-like mutual funds—in effect, having someone else buy Buffett-
type stocks for you. Even granting that Buffett is in a class by
himself, cheap imitations—cheap in the sense of your being able to
buy many shares for a low minimum—aren’t to be sneezed at. These
funds, in some cases, do not deliberately emulate Buffett’s strategy.
For example, Third Avenue Value, under Martin J. Whitman, doesn’t.
Others, to a certain extent, do—notably, Sequoia, Tweedy, Browne
BUYING BUFFETT-LIKE MUTUAL FUNDS 3
Getting Into Closed Funds
With a fund closed to new investors, you can ask a current shareholder to sign
over just one share to you and use that one share to obtain more shares on
your own. Unfortunately, owners of Sequoia shares have, in my experience,
never evinced any interest in selling shares.American Value, Legg Mason Focus Trust, Torray, Longleaf Partners,
and Vontobel U.S. Value.
Which fund most resembles Berkshire? No doubt Sequoia,
which was started by a Columbia Business School friend of Buf-
fett’s and which invests a big chunk of its assets in Berkshire. (Un-
fortunately, Sequoia is closed to new investors.) Table 1.1 shows
Sequoia’s recent holdings.
Sequoia suffered a dismal 1999, along with Berkshire itself and
with many other value funds. But its long-term record is splendid.
Over the past 10 years it has outperformed the S&P 500 by 2.31 per-
centage points, returning 17.56 percent a year.
Which of the other funds most resembles Sequoia? Buffett has
reportedly said that the Clipper Fund is close to his investing
style.
A lesser-known fund that has much in common with Berkshire is
Vontobel U.S. Value, run by Edwin Walczak. He readily acknowl-
edges Buffett’s in?uence; his portfolio recently had a 5 percent expo-
sure to Berkshire, its ?fth largest position. Other stocks in Walczak’s
portfolio that have overlapped with Berkshire: Mercury General,
Gannett, McDonald’s, Gillette, Wells Fargo. The fund is classi?ed by
Morningstar as mid-cap value.
One possible way to search for other funds that imitate Buffett’s
4 IT’S EASY TO INVEST LIKE WARREN BUFFETT
TABLE 1.1 Sequoia’s Holdings (3/31/00)
STOCK% OF ASSETS
Berkshire Hathaway A31.43
U.S. Treasury note 6.125%14.98
Freddie Mac13.09
First Third Bancorp10.23
Progressive7.88
U.S. Treasury note 5.5%6.51
Harley-Davidson4.00
U.S. Bancorp2.47
Household International1.79
National Commerce Bancorp0.58
Mercantile Bankshares0.27
Data Source: Morningstarstrategy is to compare their R-squareds, numbers indicating how
closely a fund follows an index.
You might search for a fund with an R-squared close to Sequoia’s.
(If A is equal to B and B is equal to C, then A is equal to C.) The Van-
guard Index 500, which mirrors the Standard & Poor’s 500 Stock In-
dex, has an R-squared of 100. The higher the R-squared, the more
closely a fund mirrors an index. (Table 1.2 lists the R-squareds of
some Buffett-like funds.)
BUYING BUFFETT-LIKE MUTUAL FUNDS 5
TABLE 1.2 R-Squareds of Buffett-like Funds
FUNDR-SQUARED
Sequoia37
Tweedy, Browne American Value70
Legg Mason Focus Trust79
Torray71
Third Avenue Value52
Clipper63
Longleaf Partners49
Vontobel U.S. Value27
Data Source: Morningstar
Understanding R-Squared
R-squared measures how much of a mutual fund’s performance is explained by
its similarity to an entire market. If a fund owns large-company stocks, both
growth and value, and they are well diversi?ed by industry, it should have a
high R-squared compared to the Standard & Poor’s 500 Stock Index. Fidelity
Disciplined Equity has an R-squared of 93. A fund that deliberately attempts to
duplicate the Standard & Poor’s 500 might have an R-squared of 99. (The
Vanguard Index 500 Fund, which mirrors the S&P 500, actually has an R
squared of 100.) A fund that is nowhere near as well diversi?ed by industry, or
that buys small-company stocks or foreign stocks, might have a very low R-
squared (compared to the S&P 500, but not compared to other indexes). The
Fasciano Fund, which specializes in small companies, has an R-squared of 64.
Vanguard Emerging Markets Stock Index has an R-squared of 54 compared
with the S&P 500, but 78 when compared to a foreign-stock index.Apparently R-squared is simply not a useful guide to identifying
Buffett-like mutual funds, perhaps because the concentrated nature
of some Buffett-like funds loosens their ties to the S&P 500.
Now let’s look at the same funds, zeroing in on (1) concentration,
(2) low turnover, (3) low price-earnings ratios, and (4) low price-
book ratios. (See Table 1.3.) Even with these criteria, it’s hard to tell
which fund is most similar to Sequoia.
Value funds differ from one another because their criteria for as-
sessing what a company is worth may be different. Many managers,
like Buffett, use the current value of future cash ?ow; others may
check the prices paid for similar companies recently taken over.
Some managers are “deep value”; others, further along the contin-
uum toward growth. Value versus growth investing will be covered
in Chapter 6.
In any case, Buffett-like stocks or mutual funds might constitute
only a portion of your portfolio. Value funds do tend to underper-
form during long stretches of time, and you might do well to own
some good growth stocks and growth mutual funds, along with
Buffett-like stocks, just to keep your portfolio more stable over
the years.
6 IT’S EASY TO INVEST LIKE WARREN BUFFETT
TABLE 1.3 Statistics of Buffett-like Funds
AVERAGEAVERAGE
P/EP/B
FUNDCONCENTRATED?TURNOVERRATIORATIO
SequoiaYes1224.6*4.9
Tweedy, BrowneNo1920.64.1
American Value
Legg Mason FocusYes14339.6
Trust
TorrayNo3325.14.5
Third AvenueNo525.82.9
Value
ClipperYes6318.44.7
LongleafYes5019.33.2
Partners
Vontobel U.S.Yes6719.33.6
Value
*Based on 50% or less of stocks.
Data Source: MorningstarA Sensible Solution
All in all, a sensible solution for a Warren Wannabe is to own:
•Some shares of Berkshire Hathaway
•Some of the individual stocks that Berkshire owns, or other
Buffett-like stocks
•A mutual fund or two that seem Buffett-oriented
A SENSIBLE SOLUTION 7CHAPTER 2
The Achievement
of Warren Buffett
Warren Buffett is widely acknowledged to be the best investor of
our time. When John C. Bogle, founder of the Vanguard Group,
named three investors who seem to have been able to beat the mar-
ket because of their special gifts, they were Buffett, Peter Lynch
(formerly of Fidelity Magellan), and John Neff (formerly of Vanguard
Windsor).
In the 36 years that Buffett has been the chairman of Berkshire,
its per-share book value has climbed more than 23 percent a year.
(The change in value is the best way to evaluate an insurance com-
pany’s performance.) In 32 of those 36 years, Berkshire has beaten
the S&P, sometimes by astonishing amounts. (See Table 2.1.) The
stock has risen from $12 a share to $71,000 at the end of 2000, an an-
nual growth rate of 27 percent.
9
Soros’ Dilemma
When Ron Baron, the fund manager, worked for Soros, Soros told him he
wasn’t interested in stock tips. He had too much money to invest. He needed
themes.10 THE ACHIEVEMENT OF WARREN BUFFETT
TABLE 2.1 Berkshire Hathaway vs. the S&P 500
ANNUAL PERCENTAGECHANGE
IN PER SHAREIN S&P 500
BOOK VALUE OFWITH DIVIDENDS
YEARBERKSHIREINCLUDEDRELATIVE RESULTS
196523.810.013.8
196620.3(11.7)32.0
196711.030.9(19.9)
196819.011.08.0
196916.2(8.4)24.6
197012.03.98.1
197116.414.61.8
197221.718.92.8
19734.7(14.8)19.5
19745.5(26.4)31.9
197521.937.2(15.3)
197659.323.635.7
197731.9(7.4)39.3
197824.06.417.6
197935.718.217.5
198019.332.3(13.0)
198131.4(5.0)36.4
198240.021.418.6
198332.322.49.9
198413.66.17.5
198548.231.616.6
198626.118.67.5
198719.55.114.4
198820.116.63.5
198944.431.712.7
19907.4(3.1)10.5
199139.630.59.1
199220.37.612.7
199314.310.14.2
199413.9.312.6
199543.137.65.5
199631.823.08.8
199734.133.40.7
199848.328.619.7
19990.521.0(20.5)
20006.5(9.1)15.6
Source: Berkshire HathawayPerhaps other investors have made more money. Author John
Train, in his latest book, Money Masters of Our Time, contends
that George Soros, the hedge fund manager, has been more
successful.
But Soros’ strategy is rather inimitable (not many of us could have
made billions by shorting the British pound), and his writings are
somewhat inaccessible to the ordinary investor.
In contrast, Buffett has put together an extraordinary record by
doing (in many cases) what the average investor could have
done—buying shares of GEICO, Coca-Cola, Gillette, and other
publicly traded companies. Also, his pronouncements have not
been mysteries wrapped in enigmas. Time and again he has ex-
plained what he does and what he doesn’t, and why. He has gener-
ally urged investors to follow his straight-from-the-shoulder, easy
to follow precepts that essentially boil down to this: Buy wonder-
ful companies when their stocks are a little cheap, then hold them
forever.
Buffett’s writings are—for the most part—easy to understand,
leavened with a lively wit and funny stories, and convey the sense
that he is having a wonderfully good time. And, while he has not
made himself as available to the press as some of us would like (he
courteously declined an interview for this book), he has not been as
standof?sh as many others.
Buffett—both his persona and his real personality—seems to ap-
peal to and intrigue a great many people. There is his faux naif, “aw
shucks” persona: The fourth-or-so richest person in America (ac-
cording to Forbes) wears rumpled suits, dines on hamburgers and
cherry Cokes at fast-food restaurants, lives in a big old house in Om-
aha, has rarely ventured beyond Omaha, and has made a fortune in
the stock market doing simple, obvious things that anyone else
could do. He seems like the kid who catches a record-sized bass us-
ing a wooden stick as a ?shing pole and a rusty old hook. Huck Finn
THE ACHIEVEMENT OF WARREN BUFFETT 11
Getting to Warren
About 15 years ago, as a matter of fact, I came close to interviewing Buffett. I
was writing an article for Sylvia Porter’s Personal Finance Magazine on what
successful investors would tell young people—high school students, say—
about investing. Buffett’s secretary, a friendly voice on the phone, asked me to
call the next day and she would have an answer. I did. She told me, with
unfeigned admiration in her voice, “You came very close!”conquers Gotham. Some of this is true, or was true. Some of it is not.
Don’t forget that he also went to Columbia Business School; studied
under one of the audacious and original investment minds of our
time, Ben Graham (who gave him, reportedly, the only A+ he ever
handed out); and in his investments, uses arbitrage, preferred stock,
and other somewhat off-the-beaten-path strategies. Huckleberry
Finn he’s not.
Buffett also has a reputation for decency and honesty, and this is
clearly deserved. When Salomon Brothers got into a pickle, Buffett
was the logical man to straighten things out. When a local baseball
team needed ?nancial help, Buffett proved their benefactor.
He is careful about his reputation, time and again making sure that
shareholders know that he’s not engaging in any hanky-panky. If you
order T-shirts that say Berkshire Hathaway on them, you are assured
that the money won’t be taken out of your credit-card account until
the shirts are on the way. You’re also told it may take a month for the
shirts to arrive; they arrive in a few days.
Buffett is unshakably loyal to his friends. He never loses an oppor-
tunity to express his admiration for Ben Graham, coming to New
York City to attend Columbia University festivities celebrating Gra-
ham, and sometimes just dropping in to astonish students at the
business school.
Buffett is especially loyal to his shareholders, many of whom are
old-time friends. For around ?ve hours once a year, he and Charlie
Munger answer shareholders’ questions. (Other companies, to avoid
shareholders, have been known to schedule their annual meetings in
faraway places in the dead of night.) As Buffett’s friend, the Fortune
writer Carol J. Loomis, has written, “... this is a company that thinks
?rst and foremost about its shareholders. ...”
Not surprisingly, Berkshire is No. 7 on Fortune’s list of most ad-
mired companies in America.
Warren Wannabes
Buffett has an army of Warren Wannabes, from money managers
who try to imitate his strategies down to the letter (Edwin
Walczak, who manages Vontobel U.S. Value and calls himself a
Buffett Moonie) as well as individual investors strongly in?uenced
by his views.
Peggy Ruhlin, a Certi?ed Financial Planner in Columbus, Ohio,
has never met Buffett and been to only one annual meeting. “Unless
you’re a complete fanatic, one is enough,” she reports. “Still, it’s a
once-in-a-lifetime experience. Before the meeting people are lined
12 THE ACHIEVEMENT OF WARREN BUFFETTup an hour or two ahead outside the meeting room, and when the
doors open they run in as fast as they can, jumping over rows, stand-
ing on chairs, just to be up close. Many wear the Nebraska colors,
red and white.” (She attended her only meeting before the Yellow
Hatters, a fan club, became so vociferous.)
Buffett has been so spectacularly successful an investor, Ruhlin
believes, because “he buys only what he knows. And he buys well-
managed companies, takes a hands-off attitude, and leaves every-
thing in place. He really is an outside investor.”
In buying part and not complete ownership of companies, like
Coca-Cola and Gillette, she believes, his purchases “have not always
been so stellar. Some have been good, some have been bad.”
She herself follows the value investing philosophy. “I’ve read Gra-
ham and Dodd [Security Analysis by the two Columbia professors,
Benjamin Graham and David Dodd], and it’s been hard to be a value
investor these past few years. Some of my clients aren’t 100 percent
value. Some of them are 50 percent in growth. But almost all of my
clients own Berkshire Hathaway, the A shares or the B shares. At our
of?ce, we even have a Warren Buffett Room.
“As a person, he’s easy to like. He’s so self-deprecating. He’s
a regular person, and he has good Midwestern values, which I re-
late to.”
Someone else who has attended an annual meeting is David
Braverman, the Standard & Poor’s analyst, who went with his 16-
year-old daughter, Stacey, who owns one B share. She ran into
Buffett at a jewelry store, and because he likes young people, he
went over to her and whispered into her ear: “I want to give you a
hot stock tip: Buy the next Internet stock IPO at its opening on
Monday.”
At the meeting itself, Stacey asked a question—then publicly
thanked Buffett for recommending his favorite Internet stock. The
audience roared.
Buffettology or Mythology?
People with an ax to grind may be dubious of Buffett’s accomplish-
ments, and one ax they typically are seeking to have ground is their
adherence to the Ef?cient Market Hypothesis, the notion that stocks
are always reasonably priced because all information about all com-
panies is immediately dispersed to the general populace, and the
general populace is composed of equally intelligent, rational individ-
uals. One person who harbors doubts about Buffett’s abilities is
BUFFETTOLOGY OR MYTHOLOGY? 13Larry E. Swedroe, an advocate of index funds and the author of
What Wall Street Doesn’t Want You to Know (New York: St. Martin’s
Press, 2001).
He professes himself to be an “agnostic” regarding Buffett.
Certainly Buffett’s long-term record is impressive, Swedroe ad-
mits, and it may have three causes:
1.He may be a genius.
2.He may have been just lucky.
3.He may have bene?ted specially from his being an active partic-
ipant in companies he buys into, such as Coca-Cola and
Gillette. “He often takes an in?uential management role, includ-
ing a seat on the board of directors, in a company in which he
invests.” So it may be his contribution to the companies in
which he invests that explains his record.
(One might add: Another explanation someone might advance is
that Berkshire has used the ?oat from its insurance company premi-
ums to compound its returns—at little or no cost. This, observes an-
alyst Braverman, is akin to Buffett’s having used leverage, or
borrowing money.)
Swedroe continues: From 1990 to February 29, 2000, Berkshire
gained 407 percent. But that was only 0.2 percent per year
more than the S&P 500. Swedroe then does some data mining,
and, he admits, searches speci?cally for periods of time when
Berkshire Hathaway under-performed. From June 19, 1998, its all-
time high, to February 29, 2000, Berkshire fell 46 percent. The S&P
500 rose 24 percent, not including dividends. From 1996 through
1999, Berkshire rose by 75 percent. But the S&P 500 climbed by
155 percent.
The lesson from Buffett’s record, Swedroe concludes, is that
“choosing active managers, even perhaps the greatest one of all, is
no guarantee of better results.” Whereas diversifying among index
funds, he argues, is.
The obvious answer to Swedroe is that the 1990s were a great time
for the S&P 500 Index because technology stocks ruled the roost, es-
pecially in the last few years of the decade, and the S&P 500 was
dominated by its tech stocks. For Berkshire to have beaten the index
by even a small amount over that period of time is impressive, con-
sidering Buffett’s aversion to technology stocks. And the fact that
Berkshire endured some mediocre years and some poor years is not
surprising; the S&P 500 has suffered dry spells as well. In any case,
value stocks are notorious for trailing behind the general market
14 THE ACHIEVEMENT OF WARREN BUFFETTduring long time periods, which might explain why value investors
wind up being so generously rewarded.
Why It’s So Hard to Beat an Index Fund
Beating the stock market, as represented by an index fund, is fero-
ciously dif?cult, which is why Buffett’s record is so unusual. Here
are a few reasons why a large-company index fund, like one mod-
eled on the S&P 500, is so formidable an opponent:
•The Standard & Poor’s 500 is well diversi?ed by industry.
•It is well diversi?ed by stocks. (The Vanguard 500 Index has
around 506 stocks, the extra ones being for both A and B shares,
like those of Berkshire Hathaway, which—for some strange rea-
son— are not in the S&P 500.)
•An index fund based on the S&P 500 will normally have low ex-
penses. There are few changes in its composition, so trading
costs are minimal; there aren’t high salaries for a manager or for
various analysts.
•Most index funds are capitalization weighted; the bigger compa-
nies (measured by price times shares outstanding) have more ef-
fect on the index than the smaller ones. So, in a sense, an index
fund practices momentum investing; stocks that do well begin to
occupy a greater and greater role in the index, and stocks that do
poorly begin to occupy a lesser and lesser role. This explains
why value investing and index-fund investing may alternate peri-
ods of glory. If they buy stocks in the S&P 500 Index, value in-
vestors tend to buy the companies that have been shrinking.
•The indexes are not so passively managed as some people
think. The better companies are chosen for the index in the ?rst
place; when a stock must be replaced, it is replaced by a stellar
company; when a company already in the index has been doing
abysmally, like Westinghouse or Woolworth, it may also be re-
placed by a thriving company. (Granted, the committee that de-
cides which securities should remain in an index and which
should be booted out is not infallible; in 1939, IBM was kicked
out of the Dow Jones Industrial Average.)
•An index fund won’t have a manager to blame if the fund does
poorly; shareholders may be more likely to continue holding on
because, clearly, there’s no one to heap abuse on for any mis-
take. Shareholders may be more likely to desert an actively
managed fund—and when they do ?ee, the manager may be
forced to sell stocks at what may be the wrong time. Or the
BUFFETTOLOGY OR MYTHOLOGY? 15manager may be discharged, and his or her successor may
drastically revamp the portfolio—just when the ?rst manager’s
strategy is ?nally kicking in. I once told John Bogle that one
bene?t of an index fund is that the guy who’s not managing it
today will be the same guy who’s not managing it 20 years from
now. He smiled.
16 THE ACHIEVEMENT OF WARREN BUFFETTCHAPTER 3
Buffett: A Life in
the Stock Market
I
n some ways Warren Buffett resembles another plainspoken, outspo-
ken, ordinary-but-not-so-ordinary Midwesterner: President Harry
Truman. This is so even though Truman, after having been burned in a
zinc mining adventure, mostly con?ned his investing to Treasuries.
Many of the terms used to describe Truman describe Buffett
equally as well. Historian David McCullogh called Truman a man
“full of the zest of life.” Others talked about his “fundamental
small-town genuineness,” and his “appealing mixture of modesty
and con?dence.”
17
Against Ostentation
Truman thought little of the palace at Versailles, feeling that the money to
build it had been “squeezed” from the people. In a similar vein, Buffett was
contemptuous of William Randolph Hearst’s self-indulgent San Francisco
castle, San Simeon, with its art treasures from all over the world. He felt that
it had taken “massive amounts of labor and material away from other societal
purposes.”Much like Buffett, Truman was known for his integrity and charac-
ter, and for being scrupulously ethical. These traits seem to have
served Buffett and Truman equally well.
Warren Edward Buffett was born in Omaha on August 30, 1930,
the son of Howard Buffett, a stockbroker and later a Republican
congressman. He was the second of three children, and the only son.
From his father Buffett learned the basic moral values, possibly
along with a deep respect for people who have money—his father’s
clients. From his mother, who was dif?cult and disapproving, he
may have developed a strong need to prove his worth, perhaps by
accumulating a large fortune.
In his youth Buffett displayed his intellectual gifts by memorizing
the populations of scores of U.S. cities. He displayed his commercial
instincts by selling chewing gum to passersby, setting up a lemonade
stand, selling cans of soda pop, even selling a tip sheet at the track.
He played Monopoly for hours.
When he was 11, he began working in his father’s brokerage ?rm,
marking prices on a blackboard. He bought his ?rst stock when he
was 11: three shares of Cities Service Preferred, at $38 a share. The
price fell to $27, then bopped up to $40, at which point he sold. His
pro?t was $6, minus commissions. The stock soon rose to $200 a
share; perhaps Buffett had learned a lesson in being patient.
When his father was elected to Congress, he took his family to
Fredericksburg in Virginia. Warren, who all his life has been upset at
the prospect of change, was wretched. He was allowed to return to
Omaha and live with his grandfather, Ernest. Later, he worked in his
grandfather’s grocery store.
Buffett returned to Washington, D.C., as a teenager. He began de-
livering the Washington Post and other newspapers, and in 1945, at
14, took his savings from his paper routes and bought 40 acres of Ne-
braska farmland for $1,200 and leased them to a farmer. He also
made money by searching for lost golf balls on a golf course, and by
renting old, repaired pinball machines to barber shops.
In high school, he was something of a nerd; he wore the same
18 BUFFETT: A LIFE IN THE STOCK MARKET
His Picture in the Paper
At seven, Buffett was hospitalized. In bed, he played with numbers, explaining
to his nurse, “I don’t have much money now, but someday I will and I’ll have
my picture in the paper.”sneakers all the time, even in the dead of winter. But he had devel-
oped such a reputation for stock-market wisdom that even his
teachers would ask him for advice. He graduated high school 14th
in his class of 374, and the yearbook described him this way: “Likes
math ... a future stockbroker.”
He went on to the Wharton School of Finance, where, Warren re-
ported, he knew more than his professors. And, indeed, he was a
standout student. After a year, he transferred to the University of Ne-
braska in Lincoln.
He himself dabbled in charting and technical analysis, but then,
while a senior at the University of Nebraska, read Benjamin Gra-
ham’s The Intelligent Investor, advocating that investors buy good,
cheap companies and hang on—and the veils promptly fell from
his eyes.
At 19 Buffett applied to and was turned down by the Harvard Busi-
ness School, surely a blunder as egregious as the Boston Red Sox’s
selling Babe Ruth to the Yankees. He then moved to New York to
study with Ben Graham at the Columbia Business School. He was a
splendid student.
After getting his M.B.A., Buffett applied for a job with Graham’s
?rm, offering to work for no pay, but was turned down. Buffett wasn’t
resentful: He joked that Graham had “made his customary calcula-
tion of value to price and said no.”
At the same time that Howard Buffett lost his seat in Congress,
Warren received a phone call from Ben Graham. He offered Buffett a
job as an analyst with Graham–Newman in the Chanin Building on
43rd Street. There Buffett shared a room with Walter Schloss (Chap-
ter 26), and later with Tom Knapp, who started the Tweedy, Browne
funds (Chapter 24).
Although he admired Graham, Buffett complained that he “had
this kind of shell around him.” Graham also didn’t really say yes to
Buffett’s proposed stock picks—or anyone else’s. He also discour-
aged Buffett from visiting companies and talking to management. Ei-
ther a stock ?t Graham’s mathematical matrix or it didn’t.
Buffett began courting Susan Thompson, and when she didn’t re-
turn his affection, befriended her father. Susan was dating Milton
Brown, a Jew, and Susan’s parents—her father was a Protestant min-
ister—were disapproving. Buffett told Susan’s father that he was
Jewish enough for Susan and Christian enough for him. (“Jewish
enough for Susan” probably meant: He was unconventional and
iconoclastic.) Eventually Susan gave in to her father, and began dat-
ing Buffett; they married in 1952.
BUFFETT: A LIFE IN THE STOCK MARKET 19In 1956 Graham retired to California, and Buffett—now worth
$140,000 thanks to shrewd investing—returned to Omaha.
There, Buffett began working in his father’s business. The ?rst
stock he sold: GEICO. Then he started his own investment part-
nership. He persuaded a group of investors to hand over $25,000
each; Buffett contributed $100, and he was on his way. His goal: to
beat the Dow Jones Industrial Average by an average of 10 percent
a year.
When he ended the partnership in 1969, because he couldn’t ?nd
cheap stocks to buy, his investments had compounded at 29.5 per-
cent a year versus the Dow’s mere 7.4 percent a year. Ending the
partnership was a good call. The Dow plunged in 1973 and 1974.
Buffett suggested that his ex-partners invest money with his
friend Bill Ruane in a new mutual fund called Sequoia. (See Chap-
ter 21.)
In 1962, Buffett had begun buying cheap shares of a textile mill in
New Bedford, Massachusetts, called Berkshire Hathaway. He began
buying it at less than $8 a share, then took it over completely in 1964,
when its book value was $19.46.
He had promised to hold onto the textile mill, but eventually
had to give it up because the business was eroding thanks to for-
eign competition.
He then went into insurance, a wise decision because insurance
20 BUFFETT: A LIFE IN THE STOCK MARKET
A Telling Anecdote
The Omaha Club, a downtown dining club for businessmen, did not admit
Jews, and at least one Jewish businessman told Buffett that he was upset.
When Buffett mentioned this to the club’s board, he was told, “They have their
own club.” Buffett argued that some Jewish families had been in Omaha for a
hundred years, they had contributed to the community, and yet they could not
join a club that a Christian newcomer could join immediately. “That is hardly
fair.” (“Fair,” along with “certainty,” is one of Buffett’s favorite words.)
Buffett then applied for membership in the all-Jewish Highland Country
Club. Astonishingly, some of its members didn’t want to accept him, claiming
that Gentiles would wind up taking over the club. (These members, obviously,
had goyishe kopfs.) On October 1, 1969, Buffett was admitted. The Omaha
Club promptly began admitting Jews.
With characteristic modesty and good humor, Buffett explained that he had
wanted to join the Highland Club only because the food was better.companies give their owners free money from customers to invest
for a time (until claims must be paid)—and Buffett knew how to in-
vest spare money.
When the markets crashed in 1973–1974, Buffett went in with a
wheelbarrow and scooped up bargains.
His wife, Susan, apparently didn’t enjoy the good, quiet life in Om-
aha as much as Buffett did, and moved to San Francisco, helping him
?nd another housemate, Astrid Menks, a Latvian-born waitress at a
local cafe. Mrs. Buffett nonetheless joins him on most of his public
appearances, gets along famously with Ms. Menks, and will inherit
all his stock should he predecease her.
They have three children: Howard, Susan, and Peter.
Buffett still lives on Farnam Street in the same big, gray house he
purchased 40 years ago for $31,500. He drives his own car, does his
own taxes.
The Buffett Foundation, which he set up in the mid-1960s, helps
family-planning clinics.
His most notable purchases include the Washington Post, GEICO,
Coca-Cola, Gillette, American Express, and General Re. He
prefers buying companies outright to buying partial shares, and
he now owns a well-diversi?ed portfolio of companies. (See Appen-
dix 2.)
In the early 1990s, perhaps mistakenly, Buffett and Munger got in-
volved in the Salomon scandal over its hogging of Treasury bonds,
and Buffett took over as chairman. He tried to curtail the greediness
of Salomon bond traders, and certainly managed to rescue the com-
pany from bankruptcy, but in retrospect it seems to have been a no-
win situation—a dragon that Buffett might have been better off
avoiding rather than trying to slay.
His annual reports are reader friendly, literate, learned, and some-
times funny (although he mistakenly believes that St. Augustine’s
plea, “Give me chastity, but not now,” is apocryphal).
Berkshire does things differently. Both Buffett and Munger receive
only $100,000 a year in salaries. The shares were split into A and B
varieties in 1996 only to fend off sharpies, who were about to sell
small units of Berkshire for less than the $48,000 a share it was then
selling for. (Buffett never split the stock, despite its lofty price, be-
cause he believes that low prices lead to a high turnover, attract in-
vestors who are short-term oriented, and cause stock prices to
diverge from their intrinsic value.)
The fun-?lled annual meetings, Woodstock for Capitalists, lure
thousands of contented shareholders, and every year more and more
BUFFETT: A LIFE IN THE STOCK MARKET 21people ?ock there to enjoy the Warren and Charlie Show. Celebrities
turn up, too, including Michael Eisner of Disney.
Apparently the man designated to succeed Buffett when he leaves
is Louis Simpson, GEICO’s chairman. (See Chapter 23.)
In 2001 Buffett went on what was, for him, a buying spree, pur-
chasing shares of such companies as H&R Block, GPU, and Johns
Manville, the company riddled with asbestos problems. He joined
with other very wealthy people in publicly opposing legislation to
eliminate the estate tax, arguing that it is simply unfair for one child
to be born with far more ?nancial resources than another. And he
began issuing warnings that the stock market was overvalued. He is
only 70 years old as of this writing, and one can con?dently expect
that he will be entertaining and enlightening us many more times
during this decade, and yes, even getting his picture in the papers.
22 BUFFETT: A LIFE IN THE STOCK MARKETCHAPTER 4
The In?uence of
Benjamin Graham
U.S. Steel sold for $262 on September 3, 1929. On July 8, 1932, it sold
for $22.
General Motors fetched $73 on September 3, 1929. On July 8, 1932,
it was down to $8.
Montgomery Ward was $138 in 1929. In 1932, it was $4.
AT&T was $304 in 1929. In 1932 it was $72.
Those were the better stocks. Some of the very worst stocks were
called investment trusts. These were actually what we now call
closed-end mutual funds. The problem with many of these trusts
was that they were leveraged up the Wazoo. Even more trouble-
some, they had substantial holdings in other highly leveraged trusts.
In 1929 they were ?reworks waiting for a spark.
One well-known fund, United Founders, sold for $70 in 1929. In
1932 it sold for 50 cents. American Founders was $117 in 1929. In
1932, also 50 cents.
Goldman Sachs Trading Corporation once sold for as much as
$222.50 a share. At that point its premium to its underlying assets
was 100 percent. In 1932 Walter E. Sachs was hauled before a sen-
ate committee. What, a senator asked, was the price of Goldman
23Sachs Trading Corporation stock now? Answer: approximately
$1.75.
People tend to simplify and overdramatize. The Crash of 1929
was exaggerated. The stock market’s decline through the entire
year of 1929 was only 17 percent—not enough to qualify as a bear
market, which calls for a 20 percent decline. In fact, 1930 was
worse. Even worse was to come. All in all, the stock market fell
around 80 percent from 1929 through 1932. By contrast, during the
horrendous bear market of 1973–1974, stocks lost only 45 percent
of their value.
After the Crash of 1929, many sophisticated and experienced in-
vestors, accustomed to buying when stocks retreated, bought on the
dip. After all, Herbert Hoover announced at the end of 1929 that “The
worst is behind us.” And Calvin Coolidge, the departing president,
insisted that “Stocks are cheap at current prices.” (Coolidge, famous
for his taciturnity, clearly talked too much.) These cagey investors
had their heads handed to them. Among them were Joseph P.
Kennedy, the ?rst chairman of the Securities and Exchange Commis-
sion (and father of President John F. Kennedy), along with a brilliant
young money manager named Benjamin Graham. Graham was
wiped out.
The crashes of 1929–1932 etched themselves into Graham’s mind.
Stocks and the stock market were dangerous and treacherous. To
protect himself, he was forever seeking a “margin of safety.” (Warren
Buffett was to call those words “the three most important words in
investing.”) Graham may also have been the ?rst person to claim
that the ?rst rule of investing is: Don’t lose money. The second rule
is: Don’t forget the ?rst rule. Buffett, who called Graham the
smartest man he had ever met, was in later years to say the exact
same thing.
History
Benjamin Graham was born Benjamin Grossbaum, and his family
came from England to New York City in 1895, when he was one
year old. His father, who ran a chinaware ?rm, died when Ben-
jamin was nine. His widow put her savings into the stock market
and lost it all in the panic of 1907, leaving the family in sorry ?nan-
cial shape.
Graham went to Boys High in Brooklyn, a renowned high school,
then to Columbia College. He was a genuine polymath. Graduating
24 THE INFLUENCE OF BENJAMIN GRAHAMPhi Beta Kappa, he was offered teaching posts in three Columbia
departments: English, philosophy, and mathematics. Instead he
headed for Wall Street, working as a messenger for an old-line ?rm.
Eventually he began analyzing companies and by age 25 became
partner in the ?rm of Newburger, Henderson & Loeb, earning
$600,000 a year.
In 1926 Graham formed a mutual fund, which he managed in re-
turn for a share of the pro?ts. He was soon joined by a partner,
Jerome Newman. The fund declined 70 percent from 1929 to 1932,
and Graham was thinking of surrendering. Newman put up $75,000
to enable the ?rm to survive. The ?rm eventually regained its foot-
ing and went on to prosper, although it never became especially
large. Among the people who once worked for Graham and New-
man was a young Columbia Business School graduate named War-
ren Buffett.
From 1928 to 1956 Graham had taught a popular evening course at
Columbia Business School. In 1934, at a time when people didn’t
even want to hear the word “stocks,” Graham and Professor David
Dodd published their revolutionary book, Security Analysis, a text
for serious students. Security Analysis carries on its frontispiece a
quote from Horace: “The last shall be ?rst and the ?rst shall be last.”
(Graham was a Latin scholar.)
In brief, Graham recommended buying cheap stocks, their
cheapness being apparent in (1) their price being less than two-
thirds of their net asset value, and (2) their stock having low price-
to-earnings ratios.
To Buffett, Graham’s philosophy consisted of three principles:
1.Look at stocks as real businesses, not as gambling chips to be
wagered.
2.Buy stocks cheaply—obtain a “margin of safety.”
HISTORY 25
Tough Sledding
When I asked Peter Lynch if he had read Security Analysis, he made a face and
said, “Too dry.” Readers might be interested in another book of Graham’s, The
Intelligent Investor, which features an introduction and appendix by Warren
Buffett. It is more reader friendly.3.Be a true investor. “If you have that attitude, you start out
ahead of 99 percent of all the people who are operating in the
stock market—it’s an enormous advantage.”
An Aversion to Risk
Graham was risk averse to a fault. It was hard for his employees to
persuade him to purchase a stock if it seemed to entail a slightly-
more-than-usual risk, something out of the ordinary.
When one employee, Walter Schloss, talked up a company called
Haloid, Graham told him that it wasn’t cheap enough. Haloid became
the Xerox Corporation.
David Dreman, a famous value investor of more recent times, has
argued that Graham’s investment approach was so timid that it
would have kept investors out of much of the bull market of 1947 as
well as the awesome bull market that began in 1982.
When Buffett graduated from Columbia Business School, Gra-
ham—and Buffett’s own stockbroker father—told him to keep away
from Wall Street, at least until the next crash was over.
Mr. Market
Graham’s central thesis may have been his observation that in-
vestors become too optimistic and too pessimistic, and that smart
investors should buy when investors are so gloomy they will accept
almost any price to get rid of their stinkers, and sell when investors
are so euphoric they will pay ridiculously high prices for sure win-
ners. As he put it, one should buy “when the current situation is un-
favorable, the near-term prospects are poor, and the low price fully
re?ects the current pessimism.”
A famous metaphor he invented: You are in business with a
sweet but slightly loony gentleman named Mr. Market, who hap-
pens to go to emotional extremes. Either he’s euphoric or he’s de-
pressed. And every business day Mr. Market is willing to buy our
stocks or sell us his. You can just ignore his offers. Or, when he
wants to buy your stocks at absurdly high prices, sell, and when
he wants to sell you his stocks at absurdly low prices, buy. In fact,
when Mr. Market has a great many cheap stocks to sell you, it’s
probably time to stock up in general. When Mr. Market has very
few stocks to sell, it’s probably time to sell. Graham’s greatness,
says author John Train, “may well have consisted in knowing how
26 THE INFLUENCE OF BENJAMIN GRAHAMto say no. ... He felt no need to invest at all unless everything was
in his favor.” That, of course, was a rule that Buffett has followed
carefully. (See Chapter 8.)
Another famous metaphor of his: Some good stocks are like
cigar butts. These are stocks abandoned by investors that, like
MR. MARKET 27
Graham’s 10 Signs of a Bargain Stock
A company would have to meet seven of the following ten criteria (as laid out
in Security Analysis) before Graham would consider it a cheap stock:
1.An earnings-to-price yield (the opposite of the price-earnings ratio) that
is twice the current yield of an AAA (top-rated) bond. If bonds are yielding
5 percent, the earnings yield of a stock should be 10 percent. In other
words, you could get 5 percent fairly safely; to take on the risk of a stock,
you want twice the possible reward.
2.A p-e ratio that is historically low for that stock. Speci?cally, it should be
two-?fths of the average p-e ratio the shares had over the past ?ve years.
3.A dividend yield of two-thirds of the AAA bond yield. (Obviously, stocks
that don’t pay dividends wouldn’t qualify under this rule.)
4.A stock price that is two-thirds of the tangible book value per share.
5.A stock price that is two-thirds of the net current asset value or the net
quick-liquidation value.
6.Total debt lower than tangible book value.
7.A current ratio of two or more.
8.Total debt that’s not more than net quick-liquidation value.
9.Earnings that have doubled within the past ten years.
10.Earnings that have declined no more than 5 percent in two of the past ten
years.
The individual investor, Graham counseled, should adapt these rules to his
or her own situation.
•If an investor needs income, he or she should pay special attention to rules
1 through 7—especially, of course, to rule 3, the one requiring high
dividends.
•An investor who wants safety along with growth might pay special attention
to rules 1 through 5, along with 9 and 10.
•An investor emphasizing growth can ignore dividends, but should pay
special attention to rules 9 and 10, underweighting 4, 5, and 6.cigar butts, had a few good puffs remaining in them. (One senses
that the ghost of the Depression is walking; picking up discarded
cigar butts and smoking them is what desperately poor men did
during the 1930s.)
Pay scant attention to stock market quotations, Graham advised.
Don’t become concerned by big price declines nor excited by sizable
advances.
On the other hand, Graham also recommended that investors’
portfolios be diversi?ed—just in case a bargain-basement stock
turned out to deserve its low price. For a defensive investor, 10 to
30 stocks were enough, Graham believed. (Buffett has argued for
even fewer.)
In his writings Graham stressed the cardinal difference between
investing and speculating. An investor tries to buy and hold “suit-
able securities at suitable prices.” A speculator tries to anticipate
and pro?t from market ?uctuations. A true investment, he be-
lieved, is the result of (1) a thorough analysis of the company,
which leads to a promise of (2) safety of principal, and (3) a satis-
factory return.
Graham as a Writer
Graham’s writing style was clear, muscular, lively. Buffett’s writing
style is similar.
“To achieve satisfactory investment results is easier than most people re-
alize; to achieve superior results is harder than it looks.”
“If you want to speculate do so with your eyes open, knowing that you
will probably lose money in the end; be sure to limit the amount at risk
and to separate it completely from your investment program.”
“Never buy a stock immediately after a substantial rise or sell one after
a substantial drop.” Wait until the dust settles.
“... a suf?ciently low price can turn a security of mediocre quality into
a sound investment opportunity—provided that the buyer is informed and
experienced and that he practices adequate diversi?cation.”
“... the risk of paying too high a price for good-quality stocks—while a
real one—is not the chief hazard confronting the average investor in secu-
rities. Observation over many years has taught us that the chief losses to
investors come from the purchase of low-quality securities at times of fa-
vorable business conditions.” In a bull market, you can mistake a dog for a
thoroughbred.
Another famous comment of his: In the short run, the market is
a voting machine. In the long run, it’s a scale. In other words, emo-
28 THE INFLUENCE OF BENJAMIN GRAHAMtions determine where the market is now; in the long run, reality
counts.
“The farther one gets from Wall Street, the more skepticism one will ?nd,
we believe, as to the pretensions of stock-market forecasting, or timing.”
He was not in favor of buying good companies and holding them
inde?nitely. Most businesses, he wrote, change over the years, for
the better or (perhaps more often) for the worse. “The investor need
not watch his companies’ performance like a hawk; but he should
give it a good, hard look from time to time.”
On the subject of asset allocation, Graham revealed his sense of
humor. He was in favor of an investor’s determining what percent-
age of stocks and bonds should be in his or her portfolio. “The chief
advantage, perhaps, is that such a formula will give him something
to do. As the market advances he will from time to time make sales
out of his stockholdings, putting the proceeds into bonds; as it de-
clines he will reverse the procedure. These activities will provide
some outlet for his otherwise too-pent-up energies.” Those energies
may have otherwise impelled him to go with the crowd and buy re-
cent winners.
Also: “... any approach to moneymaking in the stock market
which can be easily described and followed by a lot of people is by
its terms too simple and too easy to last.”
And: “A substantial rise in the market is at once a legitimate rea-
son for satisfaction and a cause for prudent concern.”
Many of his observations were provident. He was dubious of new
issues, initial public offerings, because they tend to be brought to
market when the pot is bubbling over.
GRAHAM AS A WRITER 29
GEICO
One of Graham’s most interesting investments came in 1948, when Graham
and Newman used $720,000, which was 25 percent of their ?rm’s total assets,
to buy a half interest in the Government Employees Insurance Company, which
sold auto insurance to government employees directly, by mail. Because
GEICO had no salespeople to pay, it could offer low rates. And government
employees tend to be especially safe drivers. Eventually the $720,000
investment was to become worth a cool $500 million.
But by 1977 GEICO was in serious trouble and had lost 95 percent of its
value at its peak. GEICO was to play a key role in Buffett’s investment career.The Later Years
Graham married three times. He liked women, Buffett observed, and
women liked him. Even though physically he resembled Edward G.
Robinson, the heavy-set actor, Graham “had style.” In his later years
Graham moved from New York to La Jolla, California, taught at the
University of California at Los Angeles, and later still settled in the
south of France, where he died in 1976.
In his late 70s, he told a friend that he hoped to do “something
foolish, something creative and something generous every day.”
(Buffett joked that Graham got the foolish thing done before
breakfast.)
His friends recognized him as a man of great kindness, but re-
served. He lived modestly. Once he and his student, Buffett, were go-
ing out to lunch at a deli, and Graham told him, “Money won’t make
any difference to you and me, Warren. We’ll be the same. Our wives
will just live better.”
He was generous with his time and with his money. On his birth-
day, he would give his employees presents. When Buffett had a son,
Graham gave Buffett a movie camera and a projector. Buffett named
the son Howard Graham, after his father, and his teacher.
Buffett on Graham
Buffett wrote of Graham’s Security Analysis, “I read the ?rst edition
of this book early in 1950, when I was about nineteen. I thought then
that it was by far the best book about investing ever written. I still
think it is....
“To me, Ben Graham was far more than an author or a teacher.
More than any other man except my father, he in?uenced my life.”
After Graham’s death, Buffett wrote this tribute to him: “A re-
markable aspect of Ben’s dominance of his professional ?eld was
that he achieved it without that narrowness of mental activity that
concentrates all effort on a single end. It was, rather, the inciden-
tal byproduct of an intellect whose breadth almost exceeded de?-
nition. Certainly I have never met anyone with a mind of similar
scope. Virtually total recall, unending fascination with new knowl-
edge, and an ability to recast it in a form applicable to seemingly
unrelated problems made exposure to his thinking in any ?eld a
delight.”
Buffett then referred to Graham’s hope to do something foolish,
creative, and generous every day of his life:
“But his third imperative—generosity—was where he succeeded
30 THE INFLUENCE OF BENJAMIN GRAHAMbeyond all others. I knew Ben as my teacher, my employer, and my
friend. In each relationship—just as with all his students, employees
and friends—there was an absolutely open-ended, no-scores-kept
generosity of ideas, time, and spirit. If clarity of thinking was re-
quired, there was no better place to go. And if encouragement or
counsel was needed, Ben was there.
“Walter Lippman spoke of men who plant trees that other men will
sit under. Ben Graham was such a man.”
BUFFETT ON GRAHAM 31CHAPTER 5
The In?uence
of Philip Fisher
Whereas Benjamin Graham emphasized buying securities cheaply
and selling them when they become reasonably priced, Philip A.
Fisher emphasizes buying ?ne companies, “bonanza” companies,
and just holding onto them. Despite their seeming differences, both
men favor conservative investments—held for the long term.
Graham was number oriented: quantitative. Fisher is more of an
artist: qualitative. Before buying a stock, he evaluates the excel-
lence of a company’s product or service, the quality of manage-
ment, the future possibilities for the company, and the power of
the competition.
Buffett seems to be ambidextrous, a disciple of both philosophies,
an investor both qualitative and quantitative.
33
Not That Fisher
Fisher is not to be confused with Yale professor Irving Fisher, remembered
best for having said in 1929, just before the crash, that stocks had seemingly
reached a permanently high plateau.Philip Fisher is a money manager and a practical, original, in-
sightful thinker. Buffett admired his book, Common Stocks and Un-
common Pro?ts (1958), and later visited with him. “When I met him,
I was as much impressed by the man as by his ideas,” Buffett wrote.
“A thorough understanding of the business, obtained by using his
techniques ... enables one to make intelligent investment commit-
ments.”
Reading Fisher, one is struck by how much in his debt Buffett is.
In fact, while Buffett has said that he is 15 percent Fisher and 85 per-
cent Graham, the split seems closer to 50 percent–50 percent.
Philip Fisher began his career as a securities analyst in 1928, after
graduating from Stanford Business School. He founded Fisher &
Company in San Francisco in January 1931, seemingly not an auspi-
cious time. But it turned out to be exactly right. After suffering two
terrible years in the stock market, investors were disgusted with
their current brokers and willing to listen, “even to someone both
young and advocating a radically different approach to the handling
of their investments as I,” he wrote in Developing an Investment
Philosophy. Besides, business was so slow, executives had plenty of
time to kill. “In more normal times,” he remembers, “I would never
have gotten past their secretaries.”
One man, on being informed by his secretary that a fellow named
Fisher wanted to chat with him, decided that “Listening to this guy
will at least occupy my time.” He became a long-time client. Later,
he told Fisher, “If you had come to see me a year or so later [when
the economy had begun reviving], you would never have gotten into
my of?ce.”
In 1932, after working many hours, Fisher wound up with a net
pro?t of $35.88. The next year, business picked up considerably: The
net pro?t surpassed $348. “This was possibly about what I would
have made as a newsboy selling papers on the street.”
But by 1935 his business was humming along, and eventually he
developed a small band of loyal and well-to-do clients.
A Growth Investor
By accompanying one of his business school professors on visits to
companies, Fisher had learned a good deal about the nitty-gritty of
businesses. He is also blessed, like Buffett and Charles Munger, with
a mind that sees the big picture, unencumbered by preconceptions
and trivialities. His book, Common Stocks and Uncommon Pro?ts
and Other Writings by Philip A. Fisher, is still impressive for both
its practicality and its subtlety.
34 THE INFLUENCE OF PHILIP FISHERFisher is squarely in the growth camp, and writes disdainfully of
value investors and their preoccupation with numbers. He grudg-
ingly admits that the “type of accounting-statistical activity which
the general public seems to visualize as the heart of successful in-
vesting will, if enough effort be given it, turn up some apparent bar-
gains. Some of these may be real bargains. In the case of others,
there may be such acute business troubles lying ahead, yet not dis-
cernible from a purely statistical study, that instead of being bar-
gains they are actually selling at prices which in a few years will
have proven to be very high.” In other words, some ugly ducklings
grow up into even uglier ducks.
In the nineteenth century, according to Fisher, value investing was
the fashion. People would buy stocks during busts and sell them for
higher prices during booms. Still, he is sure that growth investing,
buying healthy, glamorous stocks, has always been the wiser course.
“Even in those earlier times,” he writes, “?nding the really outstand-
ing companies and staying with them through all of the ?uctuations
of a gyrating market proved far more pro?table to far more people
than did the more colorful practice of trying to buy them cheap and
sell them dear.”
Fisher de?nes outstanding companies as those “that over the
years can grow in sales and pro?ts far more than industry as a
whole.” His version of growth investing targets mainly big compa-
nies, not small companies, and it calls for a buy-and-hold strategy.
While most growth investors trade frequently, those whose battle-
?elds are large-company stocks, like Fisher, generally hate parting
with their holdings.
In judging companies, Fisher is more the artist as opposed to
the scientist. That means checking out the management, learning
about company morale, studying the product or service, evaluat-
ing the sales organization and the research department—that sort
of thing.
Early in his Common Stocks book, in fact, is a chapter entitled
Scuttlebutt. You can learn a lot about a company, Fisher argues,
through the business grapevine, talking to competitors, to knowl-
edgeable people in general, in order to judge a particular company’s
research, its sales organization, its executives, and so forth. “Go to
?ve companies in an industry, ask each of them intelligent questions
about the points of strength and weakness of the other four, and
nine times out of ten a surprisingly detailed and accurate picture of
all will emerge.” You can also learn much from vendors and cus-
tomers, executives of trade associations, and research scientists.
Also interview former employees, recognizing that some may have
A GROWTH INVESTOR 35special grievances against the company. Finally, interview the com-
pany’s own of?cers.
What if the information you obtain through the grapevine is con-
?icting? Then you’re not dealing with a truly outstanding company. If
it’s a bonanza company, the information will be decidedly favorable.
Forget about companies that promise pro?ts but only temporar-
ily—because of a one-time event, such as a shortage of this metal or
that product. And be dubious of new companies.
Not that Fisher doesn’t have a foot in the other camp. Buy bo-
nanza companies when the entire market is down—or when the
stock is down because of bad news. Don’t ignore the numbers.
Check the ?nancial statements, see how much money is spent on re-
search, look into abnormal costs, study a breakdown of sales by
product lines.
Once you have identi?ed what appears to be a bonanza company,
Fisher proposed, subject the company to a 15-point test, some focus-
ing on the company itself, some on the management.
Fisher’s 15 Questions
1. Does the company’s product or service promise a big in-
crease in sales for several years? He cautions against ?rms
that show big jumps due to anomalous events, like a tempo-
rary shortage. Still, judge a company’s sales over several years
because even sales at outstanding companies may be some-
what sporadic. Check on management regularly, to make sure
it’s still top-notch.
2. Is management determined to ?nd new, popular prod-
ucts to turn to when current products cool off? Check
what the company is doing in the way of research to come up
with the newer and better.
36 THE INFLUENCE OF PHILIP FISHER
A Bonanza Company
•It has capable management, people determined that the company will grow
larger and able to carry out their plans.
•The company’s product or service has a strong potential for robust, long-
term sales growth.
•The ?rm has an edge over its competitors and any newcomers.3. How good is the company’s research department in rela-
tion to its size?
4. Does the company have a good sales organization?
Production, sales, and research are three key ingredients
for success.
5. Does the company have an impressive pro?t margin?
Avoid secondary companies. Go for the big players. The only
reason to invest in a company with a low pro?t margin is if
there’s powerful evidence that a revolution is in the of?ng.
6. What steps is the company taking to maintain or im-
prove pro?t margins?
7. Does the company have excellent labor and personnel
relations? A high turnover is an unnecessary expense. Com-
panies with no union, or a company union, probably have
good policies—otherwise, they would have been unionized.
Lots of strikes, and prolonged strikes, are obviously symp-
toms of sickness. But don’t rest easy if a company has never
had a strike. It might be “too much like a henpecked husband”
(too agreeable). Be dubious about a company that pays be-
low-average wages. It may be heading for trouble.
8. Does the company have a top-notch executive climate?
Salaries should be competitive. While some backbiting is to
be expected, anyone who’s not a team player shouldn’t be
tolerated.
9. Does management have depth? Sooner or later, a company
will grow to a point where it needs more managers, ones with
different backgrounds and skills. A good sign: Top manage-
ment welcomes new ideas, even criticism, from below.
FISHER’S 15 QUESTIONS 37
Quotable
One of my favorite passages from Fisher’s book is: Beware of companies, too,
where management is cold blooded. “Underneath all the ?ne-sounding
generalities,” he writes, “some managements have little feeling for, or
interest in, their ordinary workers. ... Workers are readily hired or dismissed
in large masses, dependent on slight changes in the company’s sales outlook
or pro?t picture. No feeling of responsibility exists for the hardships this can
cause for the families affected.” No wonder Buffett admired him when he met
him in person!10. How good is a company’s cost analysis and account-
ing? Management must know where costs can be cut and
where they probably can’t be cut. Most companies manufac-
ture a large variety of products, and management should
know the precise cost of one product in relation to others.
One reason: Cheap-to-produce products may deserve spe-
cial sales efforts.
11. Are there any subtle clues as to how good a company is?
If a company rents real estate, for example, you might check
how economical its leases are. If a company periodically
needs money, a spiffy credit rating is important. Here, scuttle-
butt is an especially good source of information.
12. Does the company have short-range and long-range
plans regarding pro?ts? A company that’s too short-term
oriented may make tough, sharp deals with its suppliers,
thus not building up goodwill for later on, when supplies
may be scarce and the company needs a big favor. Same
goes for treatment of customers. Being especially nice
to customers—replacing a supposedly defective product,
no questions asked—may hurt in the short run, but help
later on.
13. Might greater growth in the future lead to the is-
suance of more shares, diluting the stock and hurting
shareholders? A sign that management has poor ?nancial
judgment.
14. Does management freely own up to its errors? Even ?ne
companies run into unexpected problems, such as a declin-
ing demand for their products. If management clams up, it
may not have a rescue plan. Or it may be panicking. Worse, it
may be contemptuous of its shareholders. Whatever the rea-
son, forget about “any company that withholds or tries to
hide bad news.”
15. Does management have integrity? Does management re-
quire vendors to use brokerage ?rms owned by the managers
themselves, or their friends or relatives? Does management
abuse stock options? Put its relatives on the payroll at spe-
cially high salaries? If there’s ever a serious question whether
the management is mindful enough about its shareholders,
back off.
38 THE INFLUENCE OF PHILIP FISHERWhat and When to Buy
Investors should put most of their money into fairly big growth
stocks, Fisher maintains. How much is “most”? It could be 60 per-
cent or even 100 percent, depending on the investor.
In general, don’t wait to buy. Buy an outstanding company now.
What if economists fret that a recession is coming, citing all sorts of
worrisome numbers? Economic forecasting, Fisher argues, is so un-
reliable, you’re better off just ignoring it. He compares it to chem-
istry in the days of alchemy.
Obviously, if you buy a growth company when it’s somewhat
cheap, you’ll wind up doing better. So “some consideration should
be given to timing.” For example, management might have made a
mistake in judging the market for a new product, causing earnings
and share price to fall off the table. Or a brief strike has hit the com-
pany. During this time, management was buying shares like mad, but
the stock price kept retreating. Another good time to buy.
Clearly, an investor must make sure that management really is ca-
pable—and that a company’s troubles are short lived, not permanent.
What if yours is a modest portfolio and you are nervous about
stashing your savings into the stock market in one fell swoop?
What if a business bust came along? Fisher advocates dollar-cost
averaging—investing regularly over a period of time. Beginning in-
vestors, after having made a start buying big growth companies,
“should stagger the timing of further buying. They should plan to
allow several years before the ?nal part of their available funds will
have been invested.”
Fisher advocates patience. “It is often easier to tell what will
happen to the price of a stock than how much time will elapse be-
fore it happens.” In other words, stay the course. You may just be a
quicker thinker than other investors, and you’ll just have to wait
until they catch up to you. Occasionally, he warns, it may take as
long as ?ve years for excellent investments to reward you for your
perseverance.
When to Sell
In a classic statement, Fisher wrote: “If the job has been done cor-
rectly when a common stock is purchased, the time to sell it is—al-
most never.”
Only three reasons exist for selling the stock of a company previ-
ously judged outstanding:
WHEN TO SELL 391. The original purchase was a mistake. Trouble is, we may
not be ready to come clean. “None of us like to admit to him-
self that he has been wrong.” He goes on: “More money has
probably been lost by investors holding a stock they really
did not want until they could ‘at least come out even’ than
for any other single reason.” (Fisher was thus anticipating
one of the theorems of the behavioral economists, that of
loss aversion.)
2. The company has changed. Maybe the quality of manage-
ment has deteriorated. “Smugness, complacency, or inertia re-
place the former drive and ingenuity.” Forget about the nasty
capital-gains taxes you might pay. Sell. Then again, maybe the
company has simply aged, and so have its products and ser-
vices. The growth is no longer there. The company no longer
passes most of the 15 points. Again, sell. But now you can take
your time.
A good test: Will the stock climb during the next business
boom as much as it has in the past? If not, the stock should
probably be sold.
3. There’s a better buy out there. But this seldom happens.
Other reasons to hold onto a stock: The capital-gains tax. And
the fact that a stock that’s sold now just might soar during the
next bull market. And how is the investor to know when to buy
back in?
What if a stock is reported to be “overpriced”? Again, this is
mainly a matter of conjecture. Who knows what the earnings will be
two years from now?
What if a stock has made a big run-up—isn’t it time to sell now?
Hasn’t it used up most or all of its potential? Fisher’s answer: Out-
standing companies “just don’t function this way.” They tend to go
up and up and up. And you want to be there when that happens.
Things That Investors Should Not Do
• Don’t buy into initial public offerings (IPOs). There is a
greater chance for error when you invest in a company with-
out a track record. Besides, the hotshots who are launching
the company are terri?c salespeople, or inventors, but other-
wise may be nerds lacking other skills, such as a knowledge of
marketing. So even if an IPO is seductive, let others invest.
There are plenty of wonderful opportunities among estab-
lished companies:
40 THE INFLUENCE OF PHILIP FISHER• Don’t ignore a stock just because it’s not listed on the
New York Stock Exchange. (These days, with so many ?ne
tech stocks trading on Nasdaq, that advice is easy to heed.)
• Don’t buy a stock for trivial, secondary reasons, such as
that its annual report is attractive. The annual report may
just re?ect the skill of the company’s public relations depart-
ment—and not indicate whether the management team is capa-
ble and can work together harmoniously, or whether the
product or service has a rosy future. With common stocks, “few
of us are rich enough to afford impulse buying.”
• Don’t assume that a stock with a high price-earnings ra-
tio won’t ever trade any higher. If the company continues to
thrive, why shouldn’t its p-e ratio go higher still? Some stocks
that seem high priced may be the biggest bargains. (When Je-
remy Siegel of the Wharton School studied the “nifty ?fty”
stocks of the 1970s, he found that a few stocks with astronomi-
cally high ratios deserved them. Years later, it was clear that
McDonald’s, with a p-e ratio of 60 back then, deserved one of
more than 90.)
• Don’t nickel and dime things. Don’t bother about small
amounts of money. If you want to buy a good company with a
bright future, and it’s $25.50, why insist on paying just $25.40
and possibly losing out on a fortune?
• Don’t pay excessive attention to what doesn’t matter that
much. For example, past earnings and past prices-—or any-
thing past. Zero in on what’s going on now and what may hap-
pen in the future. (Not that you should completely ignore past
earnings and price ranges.)
“The fact that a stock has or has not risen in the last several
years is of no signi?cance in determining whether it should be
bought now.”
• When considering a growth stock, think about when to
buy as well as the price. Let’s say that a stock is selling at $32.
You think it might fall to $20—because $20 is what it’s really
worth right now. Or if everything turns out for the best, the
stock might climb to $75 in ?ve years. Should you buy it now?
Or wait to see if it falls to $20?
The conventional wisdom would answer: Dollar-cost average.
Nibble at it for a while.
But Fisher’s is an original mind. His curious solution: Buy the
stock at a speci?c time in the future. Maybe ?ve months from
THINGS THAT INVESTORS SHOULD NOT DO 41now, a month before a pilot plant is scheduled to go online. In
short, wait until more evidence comes in.
• Don’t follow the crowd. The conventional wisdom is often
wrong. One day, the entire investment world thinks that the
pharmaceutical industry is near death. A little later, the entire
investment world thinks the pharmaceutical industry is a cure-
all. Fisher remembers when Wall Street was sure that a de-
pression would occur after World War II. It turned out to be a
“mass delusion.”
Recognizing that the majority opinion can be just plain
wrong can “bring rich rewards in the ?eld of common stocks.”
It’s hard psychologically to buck the crowd, of course. But it
will help if you recognize that the ?nancial community is usu-
ally slow in acknowledging that something has changed drasti-
cally. (Almost all of us, in fact, feel the pain of “cognitive
dissonance” when we must change our views because of pow-
erful evidence to the contrary.)
• Don’t overstress diversi?cation. It’s true that every investor
will make mistakes, and if you have a reasonably diversi?ed
portfolio, an occasional mistake won’t prove crippling. But in-
vestors should not try to own the most but the best.
Diversi?cation is such an honorable word that investors
aren’t aware enough of the evils of being overdiversi?ed. You
may wind up with so many securities that you cannot monitor
them adequately. Owning companies you aren’t familiar enough
with may be even more reckless than not having a well-diversi-
?ed portfolio. How many stocks did Fisher think was too many?
If you have only $250,000 to $500,000, he thought that as many
as 25 was “appalling.”
Fisher’s Advice for the Small Investor
• Con?ne your investments to blue chips, like IBM and
DuPont. In this case, ?ve stocks should be enough. Put 20 per-
cent of your money into each one. What if 10 years go by, and
one of the stocks constitutes 40 percent of the portfolio—the
others not having fared quite so spectacularly? If you’re still
happy with your original choices, let things ride. Forget about
rebalancing everything back to 20 percent.
Make sure there is little overlap among these ?ve invest-
ments—that their products and services don’t compete. Don’t
buy Coke and Pepsi, or two banks, or two biotech companies.
42 THE INFLUENCE OF PHILIP FISHERStill, if you have a good reason to concentrate in one area, go for
it. It might prove a very pro?table bet.
• If you con?ne yourself to smaller companies, halfway
between the blue chips mentioned above and young,
risky growth companies with good management teams,
you might have 10 investments—each with 10 percent of
your assets. In putting together this portfolio of mid-caps,
you might underweight the riskier investments, giving them
an 8 percent cut of your portfolio rather than 10 percent, and
presumably overweighting those stocks that seem less specu-
lative.
• Then there are the truly speculative companies, those
that promise the world and where you might wind up with
sixpence. Here, Fisher’s advice is: Don’t put any money in them
that you cannot afford to lose. And if you’re a larger investor, be
sure that your original investment is no more than 5 percent of
your total portfolio.
How to Find Growth Stocks
Identifying growth stocks that you should buy and perhaps hold
onto forever and ever is, in Fisher’s opinion, a multi-part process.
1. Winnow down the names of promising stocks. The best
source: professional investors who have proved their worth.
They provide around 80 percent of his best tips. In second
place: friendly business executives or scientists. Rarely do
good tips come from brokerage bulletins or from ?nancial or
trade magazines. (These days you can’t walk down the street
without tripping over a few stock tips. Most of them, so to
speak, have been around the block a few times. Still, in my own
opinion, recent tips in the media from top people, whose repu-
tations are on the line, may be worth paying attention to. Some
professional investors even rush out to buy Barron’s on Satur-
day mornings every week, when it ?rst comes out.)
2. Next, study the ?nancials. Look at sales by product line, the
competition, insider ownership, pro?t margins, extent of re-
search activity, abnormal costs in previous years. Talk to key
customers, competitors, suppliers, former employees, scien-
tists in similar industries.
3. Finally, approach the management. And be sure that you’re
prepared. Fisher doesn’t talk with management until he has at
HOW TO FIND GROWTH STOCKS 43least 50 percent of the knowledge he needs to make an invest-
ment. A side bene?t: The more you impress management with
your knowledge and insight, the more cooperative manage-
ment may be with you.
How many ?rms does Fisher visit for every stock he buys? An ac-
quaintance of Fisher’s estimated one in 250. Another gentleman pro-
posed one in 25. The true ratio: one to every two or 2.5. That’s
because of all the research he does. If the question had been, how
many companies does he look at, one in 40 or 50 might be correct. If
the question had been, how many companies has he considered be-
fore buying one, the answer might have been around one in 250.
44 THE INFLUENCE OF PHILIP FISHERCHAPTER 6
How Value
and Growth
Investing Differ
P
eople tend to think of “value” and “growth” investing as being at
different ends of a continuum, with “blend” in the middle.
Value stocks have low price-earnings ratios and low price-to-
book ratios. They’re cheap, or seem to be cheap. Growth stocks
have high price-earnings ratios, high price-to-book ratios. They’re
not cheap, and don’t seem to be cheap. If certain value stocks are
cigar butts, as Graham called them, growth stocks are a big box of
fresh Cuban cigars.
Blend stocks are in the middle, of course. Blend mutual funds may
concentrate on blend stocks, or have a virtually equal quantity of
both value and growth stocks—like an index fund of the Standard &
Poor’s 500 Stock Index.
But maybe these two investment strategies actually come from
the same roots.
As Chris Browne of Tweedy, Browne has pointed out, an investor
can buy property on the Upper West Side of Manhattan cheaply—or
buy property on Park Avenue cheaply. It’s just that the Upper West
Side was more reasonably priced in the ?rst place. Still, in both
cases you’re buying property that’s undervalued. Buying and holding
Park Avenue property makes this kind of growth investing similar to
value investing. GARP, it’s called, for “growth at a reasonable price.”
45As Buffett has observed, value and growth investing are con-
nected at the hip.
Quite Different
The fact that growth and value are intimately connected doesn’t
mean that they are identical, or even blood brothers. Extreme
growth and extreme value remain very different. Extreme growth is
something that Buffett never buys. And if you are to invest like Buf-
fett, you should have a clear idea of what value investing is and what
it isn’t.
Buffett did buy extreme value at one point in his career, and
then—when the amount of money he had to invest was signi?cantly
larger than the amount of extreme value stocks to buy—he shifted
toward GARP stocks, stocks of glamorous companies that, if they
weren’t exactly cheap, weren’t exorbitantly expensive either.
Let’s review some of the basic differences between growth and
value stocks.
Growth stocks are those of companies doing very nicely, thank
you. Their earnings are up, their sales are up, their prices are up. Up
are also such measures of their popularity as their price-earnings ra-
tios (price divided by last year’s earnings, typically) and the price-
book ratio (price divided by assets per share outstanding).
You can ?nd growth stocks in the daily list of companies setting
new highs for the year. Or inside the portfolios of noted growth in-
vestors, like many of the people who run Janus funds or the Alger
funds (where many Janus people trained).
Value stocks are typically those of companies down on their luck,
unloved and unwanted. Maybe they were once riding high, but now
they’re wallowing in the muck. Their price to earnings ratios are low
and their price to book ratios are low. Value investors may look for
good buys among stocks dropping to new lows for the year or inside
the portfolios of noted value investors, like some of the people de-
scribed in later chapters of this book.
Value stocks are not stocks of high-priced companies that have
fallen a bit from their highs. A growth stock must fall down an eleva-
tor shaft to become a value stock. A stock that hit $120 last week,
that earns $3 a year, has a p-e ratio of 40 ($120/$3.00). It may be $108
now, after having fallen 10 percent. But its p-e ratio would still be a
lofty 36. Even if it dropped another 20 percent, to $96, its p-e ratio
would be 32. The stock would have to drop 50 percent before its p-e
46 HOW VALUE AND GROWTH INVESTING DIFFERratio became a more reasonable 20 times earnings. Or its earnings
would have to rise from $3 a share to $6 a share.
Growth Versus Value Funds
Some key differences between average large-company growth and
large-company value funds are highlighted in Table 6.1.
Value funds tend to own companies with higher debt levels ...
to buy and sell less frequently (lower turnover) ... to pay higher
dividends ... to have lower volatility ... to suffer more modest
losses ... and to own smaller company stocks.
Surprisingly, the expense ratios of the two kinds of funds are simi-
lar. Because value funds trade less often, one might have expected
their expenses to be lower. The number of stocks in the average
portfolio was also similar, although one might have expected value
funds to have fewer—because, presumably, their managers know
their stocks better. The same situation holds true for small-value
funds and small-growth funds.
To underscore the radical differences between value and growth,
let’s look at a real, no-nonsense value ?nd: Clipper. It’s a fund whose
strategy resembles Buffett’s: assembling a concentrated portfolio of
cheap but good companies. Data are from January 6, 2001, Morningstar
Mutual Funds.
At the same time, we shall examine a real, no-nonsense growth
fund: Fidelity Aggressive Growth. It’s a fund whose strategy is the
opposite of Buffett’s, assembling a varied portfolio of expensive
GROWTH VERSUS VALUE FUNDS 47
Growth, Value, and Baseball
Baseball yields a metaphor that can explain the difference between stocks.
A growth stock is a .300-hitter, a Derek Jeter. If you want to buy him for
your team, you will pay dearly. But if he hits .300 or more, he will have been
worth it.
A value stock is someone who batted .300 ...two years ago. Last year he
hurt his wrist and hit .212. Now he comes cheap. But if his arm heals and he
hits .300 again, you’ll have what Peter Lynch has called a ten-bagger. (That
may help explain why, over the years, value stocks have fared better than
growth stocks. Value investors are being compensated for their courage in
buying out-of-favor stocks.)but fast-growing companies. Data are from May 31, 2000. (See
Table 6.2)
Typical Mistakes
A good way to keep the differences between growth and value in
mind is to focus on the worst mistakes these different kinds of in-
vestors make.
Value investors buy too soon. A stock goes down, investors buy
in—then discover there’s a basement below the basement. (It’s
called a dungeon.)
Value investors also sell too soon. A cheap stock soars—and no
longer quali?es as a value stock, so value investors will sell. Some-
times the stock keeps going up. “I’ve left a lot of money on the table,”
confessed Marty Whitman, a famous value player.
48 HOW VALUE AND GROWTH INVESTING DIFFER
TABLE 6.1 Typical Large-Value Funds versus Typical Large-Growth Funds
LARGE VALUELARGE GROWTH
MEASUREMENTFUNDFUND
Debt v. total34.5%26%
capitalization
Turnover71%120%
Yield0.80.1
Beta0.811.14
Standard18.3730.21
deviation
Biggest quarterly–12.20% (3Q, 1998)–16.50% (4Q, 2000)
loss (since 1996)
Size of typical34.3—giant46.0—giant
company held38.6—large37.6—large
24.3—medium14.3—medium
median marketmedian market
capitalization:capitalization:
$35,449 million$69,308 million
Five biggestCitigroupCisco Systems
holdingsExxonMobilEMC
IBMP?zer
SBC Comm.Sun Microsystems
Verizon Comm.General Electric
Data Source: MorningstarGROWTH VERSUS VALUE FUNDS 49
TABLE 6.2 At the Extremes
FIDELITY
DATAS&P 500CLIPPER FUNDAGGRESSIVE GROWTH
Price to earnings 33.4518.441.6
ratio
Price to book8.704.709.30
ratio
Three-year17.16%11.1%26.5%
earnings growth
rate
Price to cash ?ow2511.5031.30
ratio
Turnover63%186%
Yield1.1%2.5%0%
Beta10.371.53
Standard19.814.9250.83
Deviation
Biggest–4.31% (3Q–10.31% (2Q
quarterly loss1999)2000)
(since 1996)
BiggestFinancials andTechnology and
overweightingsStaplesServices
Size of stocks7.3% —Giant27.4% —Giant
49.3% —Large42.5% —Large
37.7% —Medium23.7% —Medium
Data Source: Morningstar
Easy Analysis
An easy way to tell which is ahead at any particular time, value or growth, is to
compare Vanguard Value Index’s return with that of Vanguard Growth Index,
mutual funds that follow the two different strategies. Vanguard now has small-
cap value and small-cap growth, mid-cap value and mid-cap growth index
funds, too, though they are newer.
When do value stocks do well and when do growth stocks? One theory is that
when people are optimistic, they buy growth; when they are worried, they buy
value. Another theory is that no one really knows when one or the other will
start doing better.Growth investors buy too late. A stock’s price soars—and the
growth player arrives just as the party is beginning to break up.
Growth investors also sell too late. A hot stock misses its earnings
estimate by a few pennies, and it’s boiled in oil, burned at the stake,
drawn and quartered.
Funds to Consider
Obviously, Buffett would not buy true growth stocks when they are
at their peak of popularity and very likely overpriced. But he would
buy ?ne companies when they are selling at reasonable prices—and
hold on and on.
Could any growth funds ?t under the Buffett umbrella? Very
few have low turnovers. Even the Torray Fund, which does, is
categorized by Morningstar as a value fund because of its low
numbers.
But a few growth funds are exceptions, a leading one being
White Oak Growth, managed by James D. Oelschlager. True, the
stocks in the fund have high numbers (price to earnings ratio, price
to book, price to cash ?ow, earnings growth); and there’s plenty of
technology spread across the fund. Still, the fund gloms onto glam-
orous names and trades very seldom. Its turnover: 6 percent in
1999, 6 percent in 1998, 8 percent in 1997, 8 percent in 1996. The
fund is also concentrated: 23 stocks with $5.5 billion in assets. The
prospectus reports that the fund “selects securities that it believes
have strong earnings potential and reasonable market valuations
relative to the market in general and to other companies in the
same industry.” Finally, the fund has a superlative record: Over the
past ?ve years, it has beaten the S&P 500 Index by more than 10
percentage points a year.
In 2001, alas, the fund hit an air pocket and fell to earth.
Another growth fund that seems to re?ect the Fisher–Munger
side of Buffett: SteinRoe Young Investor. The fund’s turnover in re-
cent years has been around 45 percent; its valuation numbers are
high but below average for a growth fund.And some glamorous
50 HOW VALUE AND GROWTH INVESTING DIFFER
White Oak Fund
Minimum investment: $2,000
Phone number: (800) 462-5386
Web Address: www.oakassociates.comnames pop up in the portfolio, intended to appeal to teenagers: Wells
Fargo and Disney, for instance.
These low-turnover growth funds assuredly don’t qualify as
Buffett-type funds. But if someone already has exposure to Buf-
fett-type stocks, a fund like White Oak might be appropriate for di-
versi?cation. In 1999, when Berkshire itself did poorly, White Oak
rose 50.14 percent.
GROWTH VERSUS VALUE FUNDS 51
SteinRoe Young Investor
Minimum investment: $2,500
Phone number: (800) 338-2550
Web address: www.steinroe.comCHAPTER 7
Buffett’s 12
Investing Principles
A
sk different people to identify what’s at the heart of Warren Buf-
fett’s investment strategy, and you may get different answers: He
buys only a few especially good securities or companies; he buys
and holds; he buys companies with a “margin of safety”—cheaply; he
buys companies that promise to grow and grow until kingdom come;
he buys companies that sit on top of a mountain and cannot be dis-
lodged; or, he buys companies whose managers sit on the right hand
of God.
All of these are true enough.
But a more unifying view of Buffett’s strategy is that, at bottom, he
is not a gambler. He invests in what he considers almost sure things.
To reduce risk to the minimum, Buffett has followed a variety of
sensible strategies, and all of them can be copied, more or less, by
investors in general. They are listed below. We will explore them in
the chapters to come.
1.Don’t gamble.
2.Buy securities as cheaply as you can. Set up a “margin
of safety.”
3.Buy what you know. Remain within your “circle of com-
petence.”
534.Do your homework. Try to learn everything important
about a company. That will help give you con?dence.
5.Be a contrarian—when it’s called for.
6.Buy wonderful companies, “inevitables.”
7.Invest in companies run by people you admire.
8.Buy to hold and buy and hold. Don’t be a gunslinger.
9.Be businesslike. Don’t let sentiment cloud your judg-
ment.
10.Learn from your mistakes.
11.Avoid the common mistakes that others make.
12.Don’t overdiversify. Use a ri?e, not a shotgun.
54 BUFFETT’S 12 INVESTING PRINCIPLESCHAPTER 8
Don’t Gamble
A
t the heart of Warren Buffett’s investment philosophy is simply
this: He has a powerful aversion to gambling. He is unusually risk
averse. If we human beings have a gene for gambling—a gene that
prompts us to want to relentlessly risk our wealth on a throw of the
dice or the draw of a card—Buffett either never had it or he has re-
pressed it.
Yet a drive to gamble is something that supposedly unites
wealthy people. In his entertaining book How to Be a Billionaire,
Martin S. Fridson argues that the very wealthy got that way by
taking “monumental risks.” True, “Not every self-made billionaire
has been a ?nancial daredevil, but all have dared to reject the
safe-but-sure path.”
Examples that Fridson gives:
Developer Dennis Washington repeatedly pledged his home as se-
curity with the bonding company underwriting his projects.
Steve Ballmer, sales chief of Microsoft, bought $46 million worth
of Microsoft stock after it received an unfavorable ruling in liti-
gation with Apple Computer.
Kirk Kerkorian was known as a high roller at Las Vegas craps
tables.
55Fridson adduces other evidence: Billionaires, he claims, tend to
be interested in card games, especially poker. Names he mentions:
H.L. Hunt, John Kluge, William Gates, Carl Icahn, Kirk Kerkorian.
Then he adds: “Warren Buffett’s fraternity brothers at the Wharton
School of the University of Pennsylvania remember him chie?y for
playing bridge.”
Buffett certainly enjoys playing bridge. He plays online; he plays in
tournaments. But as far as I know, he has never played bridge for big
money—or poker for that matter. And as card games go, bridge may
depend the least upon chance.
Fridson has a point. Wealthy businesspeople may have a knack for
judging the odds accurately, enabling them to win all sorts of con-
tests beyond gambling contests.
But Buffett is no gambler. A gambler takes adventurous risks. A
dictionary de?nition of gambling: “To stake money or any other thing
of value on an uncertain event.” Remember that word “uncertain.” If
someone bets on the odds-on favorite, is that really gambling? Is it
gambling to do what John Templeton did in the 1930s, before the
outbreak of World War II—buy one share of every stock on the New
York Stock Exchange?
Buffett puts his money only on what he considers almost sure
things. “The ?nancial calculus that Charlie and I employ,” he has
said, “would never permit our trading a good night’s sleep for a shot
at a few extra percentage points of return. I’ve never believed in risk-
ing what my family and friends have and need in order to pursue
what they don’t have and don’t need.”
Writes Chris Browne of Tweedy, Browne, “The key is certainty. Mr.
Buffett wants to invest in businesses that he is certain will have sig-
ni?cant competitive advantages 10, 20, 30 years from now. This is a
very high threshold, and eliminates most companies from considera-
tion. By knowing what he cannot do, that is, knowing that he cannot
predict earning power in 10, 20, or 30 years for most businesses, Mr.
Buffett wastes no analytical time and effort studying the ‘unknow-
ables’ and focuses on businesses he considers knowable.”
An investor, Browne points out, can understand Nestle’s Cocoa or
Listerine, and make a good guess about their earning power. But
who can estimate the future earning power of Laura Ashley’s dresses
or Ralph Lauren’s fashion items or Martha Stewart’s products?
True, Buffett does make big bets. But one can argue that a big
bet on an almost sure thing does not qualify as gambling. Would
it be gambling to bet that the ?rst President of the United Sates
was George Washington? Or that an ice cube will melt if tossed
into a ?re?
56 DON’T GAMBLEHis being risk averse makes Buffett very different from many
other investors—professionals and nonprofessionals, the successful
and the unsuccessful. Think of Peter Lynch buying a stock, so that
its being in his portfolio would prompt him to take an intense inter-
est in that stock. Or keeping the faith in Chrysler; buying all those
troubled savings-and-loan stocks in the early 1990s. (I once asked
him if he could name all the stocks in his portfolio. Of course not, he
answered; 150 of his stocks begin with the word “First.”) Think of
George Soros, shorting the British pound; losing a fortune during the
crash of 1987. Garrett Van Wagoner, whose funds had dizzying
turnovers of 778 percent and of 668 percent in a single year. Or think
of all the investors in recent years who bought Internet stocks, just
because they had been going up and up.
Make Money with Less Risk
The lesson for investors in general is that it’s possible to make a lot
of money in the stock market without being a daredevil—if you buy
cheap, if you’ve done your research, if you acknowledge your limita-
tions, if sometimes you’re a contrarian.
While many investors are indeed risk averse, fearful even of in-
vesting in stocks and not CDs, many of them are also addicted to
risk. They want excitement. They want to see their securities leap
up, or down, because it makes their adrenalin ?ow, their breath
come fast.
A pediatrician I know, Earle Zazove of Chicago, gave up the prac-
tice of medicine because, he confessed, he could diagnose what was
wrong with all the kids in line to see him just by looking across his
waiting room. So, because he was interested in investing and be-
cause many of his friends wanted him to manage their money, he
gave up the practice of medicine to become a money manager.
What startled him as he settled into his new career was that so
many of his clients wanted excitement more than they wanted prof-
its. They wanted to become rich quickly—or even poor quickly. For
them, investing was almost the same as gambling.
Some individuals, in fact, disdain mutual funds in favor of individ-
ual stocks because most mutual funds are so stable, so dull. And I
confess that I’m not especially interested in buying index funds. I
want to beat the market, not be the market. Buying an index fund, as
someone has said, is like kissing your sister (or brother).
To invest like Warren Buffett, in short, may mean that you forgo
excitement and thrills. You buy good companies temporarily out of
favor—and you just hang on. You don’t dart in and out, like day
MAKE MONEY WITH LESS RISK 57traders; you don’t buy companies that have just a few choice
breaths of life left in them; you don’t buy hot stocks, intending to
sell them just before they start cooling off. You buy stodgy and safe
almost sure things.
Buffett has compared buying stocks to a batter swinging at
pitches in baseball: If you don’t swing at a pitch that’s in the strike
zone, you may be called out. But in the investment world, if you pass
by an almost sure thing, there are no adverse consequences. So, why
not wait? And wait?
Here is how Buffett has put it:
“In his book The Science of Hitting, Ted [Williams] explains that he
carved the strike zone into 77 cells, each the size of a baseball. Swinging
at balls in his ‘best’ cell, he knew, would allow him to bat .400; reaching
for balls in his ‘worst’ spot, the low outside corner of the strike zone,
would reduce him to .230. In other words, waiting for the fat pitch would
mean a trip to the Hall of Fame; swinging indiscriminately would mean a
ticket to the minors.
“If they are in the strike zone at all, the business ‘pitches’ we now see
are just catching the lower outside corner. If we swing, we will be locked
into low returns. But if we let all of today’s balls go by, there can be no as-
surance that the next ones will be more to our liking. Perhaps the attrac-
tive prices of the past were the aberrations, not the full prices of today.
Unlike Ted, we can’t be called out if we resist three pitches that are barely
in the strike zone. ...”
Risk Aversion
Buffett’s disdain for risk can be seen in other aspects of his invest-
ment strategy.
He stays within his “circle of con?dence.” He doesn’t normally
sell short; he has mostly avoided foreign stocks; he has avoided
technology.
There is a telling anecdote about Buffett.
Every other year, he and some old friends go to Pebble Beach to
play golf. In the 1980s, Jack Byrne, who had taken over GEICO, pro-
posed a side bet among the players. If someone put up $11, then
made a hole-in-one during that weekend, Byrne would pay that per-
son $10,000. Everyone else put up the $11.
Buffett thought it over and decided that the odds weren’t favor-
able enough—at 909.9 to 1. He wouldn’t fork over the $11.
An aversion to gambling.
Perhaps his aversion to change stems in part from the trauma of
58 DON’T GAMBLEhis having to move to the Washington, D.C., area from Omaha as a
young man. But I suspect that he also avoids risk so passionately be-
cause he feels such strong loyalty to his shareholders. He is deter-
mined that they not lose any money at all. His original shareholders
did him the service of trusting him; many were friends and still are,
and many are also relatives.
In fact, while Buffett seems an affable, gentle person, I think one
thing that riles him—besides public criticism—is the suggestion that
he is not an extremely risk-resistant investor.
Would a risk-averse investor own so few stocks? Here is his
response:
“Many pundits would ... say the strategy [concentrating on a few
companies] must be riskier than that employed by more conven-
tional investors. We disagree. We believe that a policy of portfolio
concentration may well decrease risk if it raises, as it should, both
the intensity with which an investor thinks about a business and the
comfort-level he must feel with its economic characteristics before
buying into it.”
The kind of investment that Buffett prefers is, to use a word he of-
ten bandies about, “certain.” As in, “I would rather be certain of a
good result than hopeful of a great one.” And: “... we are searching
for operations that we believe are virtually certain to possess enor-
mous competitive strength ten or twenty years from now. A fast-
changing industry environment may offer the chance for huge wins,
but it precludes the certainty we seek.”
What odds does he want?
In 1965, he has written, there might have been a 99 percent proba-
bility that if he had borrowed money to invest, the results would
have been good.
Buffett wrote, “We wouldn’t have liked those 99:1 odds—and
never will. A small chance of distress or disgrace cannot, in our
view, be offset by a large chance of extra returns. If your actions are
sensible, you are certain [!] to get good results. ...”
RISK AVERSION 59CHAPTER 9
Buy Screaming
Bargains
This is the cornerstone of our investment philosophy: Never count on making a good
sale. Have the purchase price so attractive that even a mediocre sale gives good results.
—Warren Buffett
B
uffett remains mum about stocks he is buying or is about to buy,
but he has been pretty open about explaining his general invest-
ment strategy. His strategy, unfortunately, is not so simple as it may
?rst appear. He uses a number of different gauges and sometimes
buys stocks that don’t seem to ?t his criteria very snugly. And he is a
qualitative as well as a quantitative investor, using not just science
and numbers, but art.
Still, he has one vital rule: Try to buy entire companies, or their
stock, cheap. That will provide the “margin of safety” that Benjamin
Graham was so intent upon. If something goes amiss, you won’t
lose much—because a margin for error (or just bad luck) has been
built in.
Alas, it’s not easy to distinguish between a stock that’s cheap and
a stock that’s fully priced or even overpriced. A few years ago a
portfolio manager showed me a “screaming bargain,” a good com-
pany with simply unbelievably wonderful numbers: UST. Formerly
U.S. Tobacco.
In other words, a seeming screaming bargain might just turn out
to be a problem stock. And the numbers alone won’t help you decide
which is which.
Of course, one way of dealing with this is to buy a number of
61stocks that seem to be screaming bargains. Enough of them
should turn out to be the genuine article, providing you with a de-
cent pro?t.
But that’s not Buffett’s way. He wants to identify true screaming
bargains in advance, and not take a chance that some of his choices
won’t work out. He wants near certainty. Yes, there are screaming
bargains out there, and that is what Buffett is searching for—the oc-
casional, sometimes very occasional, screaming bargain.
In any case, one should remember, as the poet Richard Wilbur
said, there are 13 ways (at the very least) of looking at a blackbird.
There is no magic mathematical formula that will enable you and
your calculator to identify the stocks that Buffett might buy next.
Still, there are some relatively simple screens, as we shall see, that
can help investors identify promising companies; and the more
screens that a particular stock passes, the merrier an investor may
wind up being.
What exactly is a “screaming bargain” that Buffett is searching
for? One de?nition is a cheap stock of a ?nancially healthy company
selling an ever-popular product, employing excellent salespeople
and gifted researchers, with a splendid distribution network. All
managed by capable people.
To evaluate the ?nancial health of a company and whether its
stock is cheap or not, you can check its return on equity, book value,
earnings growth, ratio of debt to equity, and the current value of its
future cash ?ow. All are useful; none are sure?re. Which explains
why it is good for an investor to have an edge, to know a little more
about an industry or a particular stock than someone who just goes
by the numbers.
Rules of Thumb
Let’s begin with one of the most important gauges of a company’s
prosperity:
Look for companies with high and growing return on equity
(ROE).
“Equity” is the net worth of all of a company’s assets. To calculate
“return on equity,” divide the equity into net income, also called “op-
erating earnings.” (Net income is calculated after removing pre-
ferred stock dividends—but not common stock dividends.)
ROE = net income/(ending equity + beginning equity/2)
This formula calculates ROE for a speci?c time period, typically a
year. You add the value of the company at the beginning of the pe-
62 BUY SCREAMING BARGAINSriod to the value at the end of the period, then divide by two to get
the average yearly value of the company.
Example:
ROE = $10,000,000/($35,000,000 + $45,000,000/2), or 22.2 percent
You must be careful about the number on top, the numerator—
there are many ways to calculate it. Buffett excludes from yearly
earnings any capital gains and losses from a company’s investment
portfolio, along with any unusual items. He wants to focus on what
management did with the company assets during what might be an
ordinary year.
A company’s yearly return on equity tells you whether its manage-
ment has been using its assets pro?tably and ef?ciently.
“The primary test of managerial economic performance,” Buf-
fett has written, “is the achievement of a high earnings rate on eq-
uity capital employed (without undue leverage, accounting
gimmickry, etc.) and not the achievement of consistent gains in
earnings per share.”
What’s wrong with “consistent gains in earnings per share”? A
company could use a portion of its earnings in Year One to invest
conservatively (say, in a bank account) for Year Two, then use that
for Year Three, and so on. Every year, record earnings, right? Sure,
but eventually the return on equity would drop to the bank deposit’s
rate of interest.
A company could, of course, zip up its earnings by boosting its
debt, too. By borrowing a lot of money to invest, by boosting its eq-
uity-to-debt ratio, a company could readily increase its return. Not
kosher, Buffett believes. “Good business or investment decisions
will produce quite satisfactory economic results with no aid from
leverage,” he has said.
Not that he is totally dubious of debt. If there’s a ?ne opportunity
available, he wants the money to take advantage of it—even if he
must borrow. As he has said, “If you want to shoot rare, fast-moving
elephants, you should always carry a gun.”
To increase return on equity, according to Buffett, a company
can increase sales or make more of a pro?t from sales, lower the
taxes it must pay, borrow money to invest or to expand, or borrow
money at lower interest rates. It could buy another company that
has been doing well. Or sell off a losing division. Or buy back
shares. Or lay off employees whose absence would not affect the
bottom line.
A rising ROE is a good sign, especially if it’s high compared with
its competitors.
RULES OF THUMB 63By and large, returns on equity average between 10 percent and 20
percent. ROEs over 20 percent (certain industries tend to have
higher ROEs than others) are impressive, but this might be largely
because of a brisk economy. And as companies grow larger, their
ROE tends to decline. Companies with consistently high returns on
equity are uncommon. Still, high returns on equity will sooner or
later translate into a higher stock price.
The Value Line Investment Survey and Standard & Poor’s Stock
Reports will give you the data you need, or you might check such
web sites as Business.com and MSN MoneyCentral Investor.
Look for those rare companies with regular 15 percent
growth in their earnings.
Buffett wants a minimum of 15 percent to compensate him for
taxes, the risk of in?ation, and the riskiness of stocks in general.
Simple math will help you determine whether a stock may bless you
with 15 percent or more a year. Look at (1) its current price, (2) its
earnings growth rate in the past few years, or (3) look up analysts’
estimates on various ?nancial web sites. Remember that the 15 per-
cent return should include dividends.
Earnings growth can be misleading. What if revenues grew faster,
meaning that pro?ts actually declined? Or if earnings grew because
of the sale of assets? What if the company’s prosperity is already re-
?ected in the stock price? Check the company’s current price-to-
earnings ratio, compare it with its competitors’ ratios, and compare
it with its historical price-to-earnings ratio.
Look for companies with high pro?t margins.
Well-managed companies are always trying to cut costs, and a ris-
ing pro?t margin may indicate that costs have indeed come down.
The question is: Will the pro?t margin be sustainable? Maybe the
price of a raw material, like paper, came down temporarily. Or the
company enjoyed a one-time tax write-off.
Of course, some companies always have high margins (movie stu-
dios), while others tend to be relatively low (retail stores).
Look for a company whose book value has been growing
regularly.
At the beginning of his annual reports, Buffett does not trumpet
how much, or how little, Berkshire’s stock has risen. He talks about
its “book value,” what the company is worth per share, or what the
owners would receive if Berkshire went bankrupt, the company was
sold, and every shareholder received a little piece.
Since Buffett took over Berkshire in 1965, book value has grown
a remarkable 24 percent a year. Book value may not be a perfect
gauge of value, but it’s better than a stock’s price, which depends on
64 BUY SCREAMING BARGAINSthe economy, the stock and bond markets in general, and investor
psychopathology.
“The percentage change in book value in any given year is likely to
be reasonably close to that year’s change in intrinsic value,” Buffett
has said.
Companies whose book value has not changed over the years tend
to be stodgy old companies, like U.S. Steel. Their stock prices are, at
best, stable. Companies whose book value has been increasing regu-
larly tend to be fast-growing companies, and their stock prices tend
to soar alongside the growth in book value.
A company can raise its book value by boosting its pro?ts (cutting
costs, introducing popular new products or services), by acquiring
pro?table companies, and by having high returns on its assets. Berk-
shire is unusual in that its book value rises whenever the stocks it
owns rise in price.
But book value can also climb if a company issues more shares,
diluting the value of current shareholders’ stock, so be mindful of
the tricks a company can play.
Buy companies without worrisome debt.
A debt/equity ratio of 50 percent or lower is considered the indus-
try standard, although many other measures are available. A rising
debt/equity ratio may be a cause for concern. Also be wary of a big
jump in accounts payable—bills that haven’t been paid.
Buy companies whose cash ?ow indicates that they are
cheap in comparison to what they will be worth down the
road. In short, their intrinsic value is high.
The ?rm of Tweedy, Browne, whose investment philosophy re-
sembles Buffett’s, has published a paper entitled, “The Intrinsic
Value of a Growing Business: How Warren Buffett Values Busi-
nesses,” quoting—and then expanding—on what Buffett has al-
ready said about his favorite strategy.
“The value of any stock, bond, or business today,” wrote Buffett,
“is determined by the cash in?ows and out?ows—discounted at an
appropriate interest rate—that can be expected to occur during the
remaining life of the asset.”
In other words, the value of a security or a business is the cash it
generates from now on. But because cash in the future is worth less
than cash you get now (you can invest cash you get now, and very
safely, in government bonds), you must lower the value of the future
cash you might get (“discount” it) by the amount of interest on that
money that you did not receive. Ten dollars ten years from now
might be worth paying only $7 for now—depending on the interest
rate you use. The higher the current interest rate, the less you would
RULES OF THUMB 65pay now for the $10—because the more interest you would have for-
gone while waiting to collect the $10.
Next, a practical de?nition from Buffett of “intrinsic value,” or
what a company is actually worth.
Let’s start with intrinsic value, an all-important concept that offers the
only logical approach to evaluating the relative attractiveness of invest-
ments and businesses. “Intrinsic value” can be de?ned simply: It is the dis-
counted value of the cash that can be taken out of a business during its
remaining life.
The calculation of intrinsic value, though, is not so simple. As our de?n-
ition suggests, intrinsic value is an estimate rather than a precise ?gure,
and it is additionally an estimate that must be changed if interest rates
move or forecasts of future cash ?ow are revised. Two people looking at
the same set of facts, moreover—and this would apply even to Charlie and
me—will almost inevitably come up with at least slightly different intrin-
sic value ?gures.
Intrinsic value is rarely the same as market value, the value of all
of a company’s outstanding stock. Market value can be in?uenced by
investor psychology, the economic climate, and so forth. A closed-
end mutual fund, for example, may sell for more than, or less than,
or exactly for what its underlying assets are actually worth. (Such a
fund, traded as a stock, owns a variety of securities.) Usually such
funds sell at discounts, although no one is quite sure why.
In another talk, Buffett has pointed out:
If you had the foresight and could see the number of cash in?ows and out-
?ows between now and Judgment Day for every company, you would ar-
rive at a value today for every business that was rational in relation to the
value of every other business.
When you buy stocks or bonds or economic assets, you do so by plac-
ing cash in now to receive cash later. And obviously, you’re looking for the
highest [rate of return]. ...
... Once you’ve estimated future cash in?ows and out?ows, what inter-
est rate do you use to discount that number back to arrive at a present
value? My own feeling is that the long-term government rate is probably
the most appropriate ?gure for most assets . ..
... When Charlie and I felt subjectively that interest rates were on the
low side, we’d be less inclined to be willing to sign up for that long-term
government rate. We might add a point or two just generally. But the logic
would drive you to use the long-term government rate.
If you do that, there is no difference in economic reality between a
stock and a bond. The difference is that the bond may tell you what the
66 BUY SCREAMING BARGAINScash ?ows are going to be in the future—whereas with a stock, you
have to estimate it. [With most bonds, you are promised a speci?c re-
turn year after year.] That’s a harder job, but it’s potentially a much
more rewarding job.
Logically, if you leave out psychic income, that should be the way you
evaluate a ?rm, an apartment house, or whatever. And in a general way,
Charlie and I do that.
By “in a general way,” he means not slavishly. It’s not the only way
he estimates what a company is worth.
Here’s an easy example that Buffett gave: Let’s say that you have a
bond, or an annuity, that pays you $1 a year—forever—and that long-
term interest rates are currently 10 percent. What is your annuity
worth? Well, 10 percent of what is $1? Answer: $10.
But what if that annuity pays you 6 percent more every single
year? From $1.00 to $1.06 to $1.12 to $1.19 and so forth. Now your
annuity is worth more: $25 rather than $10. Obviously, the more an
investment grows in the future, the more you should be willing to
pay for it.
Tweedy, Browne has further explained how the numbers work.
What would you pay now to receive $1 in 12 months if you wanted
a 10 percent return? Answer: $0.90909 cents. That’s calculated by
subtracting the money you didn’t get during the year while you
were waiting
($1 – $0.090909 = $0.90909.)
What would you pay now to receive $1 in two years if you
wanted a 10 percent compounded rate of return on your money
over two years? Answer: 82.65 cents. Obviously, the longer you
must wait to receive your money, the less you would pay for that
future money today.
To estimate the intrinsic value of common stocks, you would esti-
mate the future cash ?ow of a company a certain number of years
from now, then ?gure out what you would pay for the stock today
for that cash ?ow in the future.
If you try to value a company whose cash earnings are expected to
grow fast, you might ?nd that even a very high purchase price is war-
ranted. As Tweedy, Browne points out, if Coke’s earnings were to
grow at a 15 percent annual rate for the next 50 years, each $1 of cur-
rent earnings would grow to $1,083.65 over 50 years. The current in-
trinsic value, assuming a 6 percent discount rate, would be $58.82, or
about 59 times current earnings.
Buffett has owned Coke when it had a very high p-e ratio of 65.
RULES OF THUMB 67But if Coke’s future earnings increase at a 15 percent yearly rate,
then a 65 p-e ratio “may turn out to be a bargain.” In short, “The math
tells you that long-run earnings growth is worth a lot.” Hence the
wisdom of buying and holding winners.
In Chapter 20, as we will see, in order to compile a list of stocks
Buffett might approve of, Standard & Poor’s analyst David Braver-
man estimates a company’s free cash ?ow ?ve years from now, being
guided by its recent growth in earnings. Then, to discount the cash
?ow that investors would receive in ?ve years, he divides the cash
?ow by the current yield on 30-year Treasuries, coming up with a
current valuation. Any stock selling for more than that, he discards.
Tweedy, Browne acknowledges the value of this method of calcu-
lating intrinsic value, but notes that you must be dealing with compa-
nies whose future cash ?ows are somewhat predictable—Coca-Cola,
for example, rather than Laura Ashley’s dress business.
68 BUY SCREAMING BARGAINSCHAPTER 10
Buy What You Know
B
uffett has certain favorite phrases, such as “margin of safety.” An-
other is “circle of competence.” He tries to invest only in compa-
nies and industries about which he is especially knowledgeable,
such as insurance companies, where he has an edge. If he is going to
buy a house, he wants to know a lot about the community (taxes,
safety, reputation of the schools, local controversies) and the neigh-
borhood (could a gas station go up next door? are schools within
walking distance?). If he is going to play any card game, for money,
he wants to be knowledgeable about the rules and thoroughly famil-
iar with time-tested winning strategies.
To specialize in certain types of investments—convertible bonds,
pharmaceutical stocks, closed-end mutual funds, semiconductor
stocks, fast-food restaurants, whatever—seems to be a perfectly ob-
vious and perfectly sensible investment strategy. If you know a little
more than other investors about one stock or one industry, you will
have a small advantage that, once in a while, could prove pro?table;
the advantage will be compounded by the self-con?dence you enjoy,
which might bolster your courage to buy more when others are sell-
ing and to sell when others are clamoring to buy.
Buffett happens to know a lot about banks. In the early 1990s,
when savings and loans across the nation were in hot water, Wells
69Fargo’s stock suffered along with everyone else’s. One respected an-
alyst was ?ercely negative about the stock; another, buoyantly opti-
mistic. Buffett knew that Wells Fargo was an exception.
Management had resisted making risky loans to foreign countries; it
had lots and lots of cash in reserve. Buffett dived in.
Specializing in one or more industries is especially suitable for
people who happen to labor in that particular line of work. Com-
puter programmers might incline toward technology stocks, journal-
ists in media, physicians in health-care stocks. As one doctor
boasted to me, he was aware of which companies always seemed to
be coming up with important new products, which companies had
the most knowledgeable salespeople, which companies were the
most respected by physicians in general.
So, why don’t investors in general establish a niche and remain
there?
There are social pressures on people to become Renaissance men
and women, to be familiar with painting, history, music, astronomy,
wine, horse racing, cards, baseball, and everything else under the
sun. All-around people, not nerds specializing in computers, mutual
funds, or residential real estate.
Even actors who can play different roles get special adulation, a
remarkable example being Robert De Niro, who has portrayed
everyone from a boxer to a mobster to a bus driver to a protective
parent.
Versatility is certainly desirable and admirable; no one wants to be
a nerd.
But versatility isn’t easy to achieve. When Jussi Bjoerling, the
great operatic tenor, was scolded for being so wooden on stage, he
scornfully replied, “I am a singer, not an actor.”
And if, as an investor, you want to carefully avoid gambling, to
avoid taking enormous risks, you should specialize in your stock se-
lections and not try to cover the waterfront. Yes, you should have a
well-diversi?ed portfolio, but perhaps by buying mutual funds in
those areas you’re inexpert in. For the individual stocks in your port-
folio, you might determine what you are good at, or what you want
to be good at, and cultivate your garden.
Buffett deliberately and thoughtfully has specialized; he has not
tried to impress other people with his versatility:
•He has generally avoided investing in foreign stocks.
•He has also kept away from technology stocks, although he was
savagely abused for this early in 2000, before the technology
disaster struck.
70 BUY WHAT YOU KNOW•He has avoided commodity-type companies, those that produce
a product that others can easily emulate and where the resulting
intense competition keeps pro?ts down.
Staying out of Technology
Explaining why he has avoided technology stocks, Buffett wrote:
If we have a strength, it is in recognizing when we are operating within our
circle of competence and when we are approaching the perimeter. Predict-
ing the long-term economics of companies that operate in fast-changing in-
dustries is simply beyond our perimeter. If others claim predictive skill in
those industries—and seem to have their claims validated by the behavior
of the stock market—we neither envy nor emulate them. Instead, we just
stick with what we understand. If we stray, we will have done so inadver-
tently, not because we got restless and substituted hope for rationality.
Fortunately, it’s almost certain there will be opportunities from time to
time for Berkshire to do well within the circle we’ve staked out.
In 1998 and 1999 Buffett resisted suggestions as well as tirades
that Berkshire invest in technology stocks, explaining that he and
Charles Munger “believe our companies have important competitive
advantages that will endure over time. This attribute, which makes
for good, long-term investment results, is one Charlie and I occasion-
ally believe we can identify. More often, however, we can’t—at least
not with a high degree of conviction. This explains, by the way, why
we don’t own stocks of tech companies, even though we share the
general view that our society will be transformed by their products
and services. Our problem—which we can’t solve by studying up—is
that we have no insights into which participants in the tech ?eld pos-
sess a truly durable competitive advantage.”
For the general public, a sensible alternative would be to buy a
lot of technology stocks—via a mutual fund, perhaps. But buying a
dozen or two dozen tech companies, betting on an entire industry,
while reasonable, is not typically Buffett’s strategy. It’s too much
like gambling.
Buffett has quoted an appropriate maxim: “Fools rush in where
angels fear to trade.”
STAYING OUT OF TECHNOLOGY 71CHAPTER 11
Do Your Homework
One of the most common mistakes made by investors is to neglect local enterprises in
favor of distant concerns. This is often very foolish, especially on the part of the small
investor, because it is much easier for him to get the essential facts in regard to a local
bond or stock.
What perverse trait of human nature makes us overlook the near-by opportunity?
Why is all the romantic glamour monopolized by far away things? ... The man with a
thousand dollars to invest displays exactly the same pathetic but very human trait
that the boy or girl who supposes they would be much happier if they could get away
from home. ...
A man in Cleveland wants to know about a picayune, irresponsible, ?y-by-night
promoter in New York. There are dozens of strong banking and brokerage ?rms in
Cleveland. A resident of Maryland wants to know about a swindling bucket shop in a
certain Western State. Does he not know that some of the oldest and strongest
investment dealers in investment securities hail from Baltimore?
—from Putnam’s Investment Handbook, by Albert W. Atwood,
Lecturer at Columbia University (New York: G.P. Putnam’s Sons, 1919)
T
here are legendary stories of Buffett’s being asked to invest in one
thing or another, and making up his mind with the speed of sum-
mer lightning. In one instance, a businessman, Robert Flaherty,
phoned Buffett at home in 1971 to ask if he would be interested in
buying See’s Candy Shops, a chain of chocolate stores in California.
“Gee, Bob, the candy business. I don’t think we want to be in the
candy business.” Then silence.
Flaherty and his secretary tried to call Buffett again, but the secre-
tary mistakenly called him at his of?ce. When she ?nally reached
him at home, after a few minutes, the ?rst thing that Buffett said
was, “I was taking a look at the numbers. Yeah, I’d be willing to buy
See’s at a price.” He bought it for $25 million.
Sometimes, when the numbers are good and the business is ?ne,
Buffett will act quickly. But otherwise he becomes an ordinary
gumshoe, trying to ?nd out everything he can about a company.
As a student at Columbia Business School, he learned that Ben Gra-
ham was chairman of Government Employees Insurance Company in
73Washington, D.C. On a Saturday, Buffett took a train to Washington
and went to GEICO’s of?ces in the now-deserted business district.
The door was locked. He kept knocking until a janitor appeared.
Buffett asked: “Is there anyone I can talk to besides you?”
The janitor agreed to take him to a man working on the sixth ?oor,
who turned out to be Lorimer Davidson, ?nancial vice president. He
and Buffett talked for four hours.
Recalled Lorimer, “After we talked for 15 minutes I knew I was
talking to an extraordinary man. He asked searching and highly in-
telligent questions. What was GEICO? What was its method of doing
business, its outlook, its growth potential? He asked the type of
questions that a good security analyst would ask. ... He was trying
to ?nd out what I knew.”
Buffett was impressed. He then visited some insurance experts,
who told him that the stock was overpriced. He came down on the
side of GEICO, and put most of his savings, $10,000, in the stock.
When he returned to Omaha to work with his father, the ?rst stock
he sold was GEICO. Today, of course, Berkshire Hathaway owns all
of GEICO.
A Gumshoe
As a gumshoe, Buffett is not like Nero Wolfe, never budging from his
New York City brownstone and his orchids, letting Archie Goodwin
go out and do all the in-person investigating. Buffett goes out into
the ?eld. He gets his hands dirty.
Byer-Rolnick manufactured hats. Buffett visited Sol Parsow, who
owned a men’s shop in Omaha where Buffett bought his suits. What
did Parsow think of that company? Said Parsow, “Warren, I wouldn’t
touch it with a 10-foot pole. Nobody is wearing hats anymore.” Cer-
tainly President Kennedy wasn’t.
Buffett listened. He didn’t buy.
Not long after, Buffett became interested in a company in New
Bedford, Massachusetts, that made suit liners. He went back to Par-
sow. “Sol, what’s going on in the suit industry?” “Warren, it stinks,”
was the reply. “Men aren’t buying suits.”
Buffett should have listened. Instead, he went ahead and kept buy-
ing shares of Berkshire.
Thinking of buying shares of American Express during a time when
that company was involved in a scandal, Buffett visited Ross’s Steak
House in Omaha. He stationed himself behind the cashier and
watched as customer after customer continued using American Ex-
74 DO YOUR HOMEWORKpress cards. He checked with banks and travel agencies in Omaha,
and yes, they were still selling American Express traveler’s checks.
He found that American Express money orders were still popular
with supermarkets and drugstores. He even spoke with American
Express’s competitors.
Buffett then bought in.
When Buffett became interested in Disney stock, he dropped in to a
movie theater in Times Square to see Disney’s latest ?lm, Mary Pop-
pins. He looked around the theater; he was the only adult not ac-
companied by a child. He also noticed how rapt the audience was
when the ?lm began. Later, Buffett actually visited with Walt Disney
himself on the Disney lot and was struck by his enthusiasm about his
own work.
Going out into the ?eld, or at least making a lot of phone calls, is a
good way to get an edge over other investors. Tom Bailey, who
founded the Janus funds in Denver, would tell his analysts to visit
the supermarkets and other stores in town and ?nd out what cus-
tomers were buying.
A smart former Fidelity money manager, Beth Terrana, once told
me about visiting a company she was interested in and interviewing
its chief ?nancial of?cer. The CEO decided to listen in on the meet-
ing, and remained for two hours. Terrana decided not to buy the
stock. One reason: Didn’t the CEO have anything better to do?
In general, money managers want company of?cers to have a
clear game plan for the future. They want to emerge from a meeting
with the managers knowing a lot more than they knew before, hav-
ing a better appreciation of the problems and the possibilities. Some-
times, listening to someone explain things, you quickly recognize
that the person has fresh, persuasive insights that you had been lack-
ing; sensible explanations for what had previously been annoying
mysteries. That can build a lot of con?dence.
As mentioned, whatever industry you already know a little about
is a good place to consider investing. A local company, or a national
company with a local of?ce, is also a good place to look. In your
hometown, you will meet employees, competitors, suppliers, cus-
tomers. The local newspaper will carry stories, “scuttlebutt,” as Phil
Fisher called it.
Investing in your own employer may not be a wonderful idea be-
cause you don’t want to keep your nest egg and your job security
in the same basket. But if you deeply admire your employer, the
risk of putting your savings where your job is may be worth it.
A GUMSHOE 75Employees of Microsoft aren’t complaining about the fortunes
they made there.
Find out everything you can about a company before you invest.
That way, not only will you know more than other people who trade
the stock; you’ll know you know more. Value investors, when they
see a stock they like go down, buy more shares.
Read the annual report and the 10-K; read the Value Line Invest-
ment Survey, Standard & Poor’s “The Outlook,” brokerage reports;
check the web site; speak with shareholder relations. Try out the
product or the service.
You might even visit stores and speak to salespeople.
That’s what Lise Buyer, a former analyst for T. Rowe Price Science
& Technology, used to do in Baltimore. Every month she would bop
around the computer shops. “What’s selling?” she would ask a clerk.
“What’s hot? What’s being returned? What are people saying? What
are they looking for? What are they complaining about?”
“Don’t those salespeople,” I asked, “?gure out that you’re a pro?”
“Yes,” she conceded with a smile, “sometimes they do, but by the
time they ?gure out who I am, they’re gone. There’s a big turnover in
computer stores.”
If you were looking for a house to buy, you would compare differ-
ent houses in different neighborhoods. You would inspect any house
you are interested in from top to bottom, even looking in the base-
ment for water stains on the walls. You would speak with the owners
(“Does the roof leak?”) and check with neighbors (“Any ?ooding
septic tanks hereabouts?”). You would hire a home inspector and a
termite inspector. You might pay for a formal appraisal. You would
dicker about the price. And then, after three months, you would buy.
And you would normally buy to hold.
Warren Buffett buys stocks the way he buys houses. And he’s lived
in his Omaha house a long, long time.
76 DO YOUR HOMEWORKCHAPTER 12
Be a Contrarian
I
f you want to outperform the stock market, to do better than the
Standard & Poor’s 500 or the Dow Jones Industrial Average, you
must be willing to be different. There’s nothing terribly wrong with
doing as well as the market by buying an index fund—if you’re an in-
dividual investor. But professionals are hired to beat the index, or at
least to do as well while incurring less risk.
You can beat the index by:
•Moving from stocks to cash or to bonds at a time when you
think stocks are overvalued, or by stocking up when you think
stocks in general are cheap
•Concentrating on buying stocks that seem cheap because in-
vestors are too pessimistic and impatient—whereas, because of
your special knowledge, you know better
•Concentrating on buying thriving companies that don’t seem ex-
cessively expensive because investors aren’t suf?ciently opti-
mistic (the growth strategy)
•Avoiding the common, almost irresistible, psychological mis-
takes that other investors make
77•Taking advantage of other investors’ misconceptions, and bet-
ting big against prevailing opinions. As Buffett once re-
marked, “I will tell you the secret of getting rich on Wall
Street. You try to be greedy when others are fearful and you
try to be very fearful when others are greedy.” Contrarian in-
vesting in a nutshell.
Investors, being of average intelligence and average perspicacity,
can jump to the wrong conclusions and misinterpret the evidence.
That’s when shrewd investors can clean up.
How often are the mass of investors extremely wrong? Not often.
That’s why Buffett and Munger talk about a few great opportunities
that may come along in a lifetime, a few really fat pitches.
Where do you ?nd grossly mispriced stocks? Some money man-
agers scout around for new acquisitions amid the list of stocks hit-
ting new lows for the year.
Where don’t you ?nd underpriced stocks? In conversations at
cocktail parties. If everyone is boasting of how much money they
made in Internet stocks for example, the end is near. Writes James
Gipson of the Clipper Fund: “The cocktail party test is an unscien-
ti?c but useful test of conventional wisdom.” This celebrated con-
trarian continues: “The best investment policy is to avoid what
everyone else is buying; the best social policy is to be discreet about
it.” You don’t want to offend people; you also don’t want them to
steal your ideas.
In my own case, the best investment decisions I ever made were
to hold on, not to sell, even when I was plenty worried. When John-
son & Johnson stock tumbled after someone poisoned a bottle of
Tylenol, I hung on. The price went down maybe 10 points, then re-
bounded, thanks to the company’s energetic efforts to snuff out the
?ames. No, I wasn’t smart enough or self-con?dent enough to buy
more shares. But I felt sure that this, too, would pass.
When the Clintons came into of?ce and prepared to shake up the
drug industry, I resolutely held onto all my health-care stocks, recog-
nizing the vast power of the health-care industry in this country.
Again, I wasn’t smart enough or courageous enough to buy more
shares. I recall giving a tip to a woman who asked for investment ad-
vice: Vanguard Health Care Portfolio, I told her. Disgusted, she
turned away. She had lost enough money on health-care stocks, she
said over her shoulder. Probably the only really worthwhile stock tip
I’ve given in my entire life.
It may not be generally recognized, but Buffett has a genius for
bucking trends. In 1975, at the end of the crash of 1973–1974, he was
78 BE A CONTRARIANbuying everything he could lay his hands on; he was a child let loose
in a toy store. In 1987, before the crash, he was complaining that
there was little to buy. In 1999 and 2000, he was skeptical of the
stock market in general.
The ?rst time I heard of Buffett was when he was buying GEICO
in 1976, when the company seemed close to bankruptcy. The stock
had been $42 in 1974; now it was below $5. I was then a resident of
New Jersey and a GEICO customer; GEICO sought a rate increase
in New Jersey and was denied. I then received a notice that GEICO
was leaving the state and would no longer offer me a policy. For
someone named Warren Buffett to be buying GEICO stock at that
time, I thought, was very, very strange.
The Contrarian Personality
Being a contrarian seems to require a certain personality type. Con-
trarian investors are in the habit of being skeptical of the conven-
tional wisdom. When the market is going up, for example, their joy is
restrained: There’s less for them to buy, and it’s time to consider sell-
ing. When the market is sinking, their spirits soar: Macy’s is having a
bargain sale.
Apparently the investing public can make big mistakes because
people have trouble dealing with complex, con?icting information—
such as on the direction of interest rates or the direction of the stock
market. People like to simplify things, to overdramatize things, to
jump to easy conclusions.
Contrarians are ready at all times to secede from the majority, to
express their sourly skeptical views. Buffett, unlike Ben Graham,
now believes that buying great companies slightly cheaply is a good
strategy, and that one need not fear that the next bear market and
the next depression are lurking around the corner.
Of course, being contrarian requires a good deal of self-con?-
dence, too. That probably comes from having a good self-image
(it helps, psychologists tell me, if your mother loved you); and
from previous and pro?table lessons gleaned about the folly of
other investors.
But it also helps to not have too much con?dence. As Gipson
has pointed out in his book Winning the Investment Game (New
York: McGraw-Hill, 1987), “Too much con?dence can be as danger-
ous as too little. Just as an insecure investor is prone to rely on
consensus thinking, an overcon?dent investor is liable to think he
can do no wrong after a period of unusually good pro?ts. ... The
investor who runs a little scared and is prepared to question
THE CONTRARIAN PERSONALITY 79assumptions, recheck analyses, and recognize mistakes early is
likely to fare better.”
Contrarian investors, he also writes, never feel comfortable when
they make their best buys. As a contrarian Neuberger Berman man-
ager once confessed to me, he tries to ignore the queasy feeling in
the pit of his stomach, holds his nose—and buys.
But Gipson is ?at out wrong when he argues that “When it comes
to making money and keeping it, the majority is always wrong.”
More people invest in index funds these days than in any other kind
of stock fund—and they are doing the right thing. But Gipson is ?at
out right when he claims that unusually successful investing, as Ben
Graham said, often entails just selling to the optimists and buying
from the pessimists.
Be Con?dent
Buffett is forever fretting about losing money and making mistakes,
but when he’s sure, he’s sure. He waits and waits, and when his pitch
comes he swings for the seats. He is modest in confessing his lack of
knowledge; he is bursting with con?dence on those occasions when
he is sure of himself. At one point in his career, American Express
was most of his investment portfolio.
Self-con?dence is something value investors need. Very often
their strategy doesn’t work, and for long periods of time. And while
they may be willing to continue carrying the ?ag with bombs ex-
ploding all around them, the people they work for or with may not
be so patient and forbearing. In 1999 some value managers actually
lost their jobs—and many others began moving further and further
toward the growth side of the continuum by nibbling on high-priced
technology stocks. Buffett himself was savagely abused by certain
individuals for not having dived in head?rst into technology. “What’s
wrong, Warren?” was the memorably misleading cover line on an is-
sue of Barron’s.
Those who dived in, not surprisingly, wound up hitting bottom.
Ignoring the Herd
It’s not just in his investing style that Buffett is unconventional. He
has no qualms that his stock stands out from the herd because of its
high price. Or that its name conveys nothing. Or that his annual
meetings are so different from other annual meetings. Or that Berk-
shire has so small a staff. Too many people, he believes, confuse the
“conservative” with the “conventional.”
80 BE A CONTRARIANHe himself doesn’t pay much mind to the voice of the people. He
isn’t interested in stock tips.
“In some corner of the world they are probably still holding reg-
ular meetings of the Flat Earth Society,” Buffett has written. “We
derive no comfort because important people, vocal people, or
great numbers of people agree with us. Nor do we derive comfort
if they don’t.”
IGNORING THE HERD 81CHAPTER 13
Buy Wonderful
Companies
H
ere are examples of stocks or entire companies that Buffett has
purchased, all of which have turned out to be big winners.
Government Employees Insurance Company
In 1976 Buffett accumulated almost 1.3 million shares of GEICO, an
auto insurance company, at an average of $3.18 per share. GEICO
was in big trouble at the time. It was actually close to bankruptcy. In
1976 the company reported a loss of $1.51 per share. The year before
it had lost $7.13 per share.
Apparently the root cause of the trouble was that GEICO was in-
suring too many problem drivers, whose claims were keeping the
company from being pro?table. A sign that a company is overex-
tended: Its sales are more than three times its equity, the value of the
stocks all shareholders own. GEICO’s insurance sales were $34 per
share in 1975, almost 16 times shareholders’ equity.
Meanwhile, its income from investments was a meager $0.98 per
share. If the company could at least break even on its insurance un-
derwriting and stop losing money, a purchase price of $3.18 per
share would be only a little more than three times the earnings of
$0.98 a share. A terri?c bargain.
83Besides, there were reasons to be optimistic. The company had
hired John Byrne, a former manager of Travelers Insurance Com-
pany, as its new president. Beyond that, GEICO had an edge: It sold
auto insurance very cheaply. Unlike almost all other auto insurance
companies, GEICO sold directly to the public, bypassing insurance
agents and their sales commissions. That gave GEICO a clear advan-
tage over other insurance companies, which would antagonize their
current agents if they decided to skip over them and sell directly—
and more cheaply.
Could another insurance company come along and compete with
GEICO? Unlikely. Yes, there was a “moat,” as Buffett would call it.
Even if a new company entered the business with low prices, GEICO
could lower its own prices. A new company obviously would have a
formidable task taking business away from GEICO.
Byrne proved to be a magician. Among other things, he dumped
bad insurance risks wherever possible, including everybody in New
Jersey—including me. Result: Between 1976 and 1995 GEICO sales
shot up from $575 million to $2,787 million, and sales per share rose
from $16.84 (adjusted for the issuance of convertible preferred stock
in 1976) to $206.44 (adjusted for stock splits).
In 1996 Berkshire Hathaway bought most of the remainder of
GEICO’s shares, at $350 a share. This price valued the shares at
20.1 times earnings, which was reasonable. From 1976 to 1996 the
compounded increase in the stock’s price was around 27.2 percent
a year.
The Washington Post Company
Buffett had paid an average of $4 a share for the Washington Post by
June of 1973. The Post owned not just the leading newspaper in the
nation’s capital, but Newsweek magazine, three television studios,
and one radio station back then. What was the Washington Post re-
ally worth? Buffett checked what other newspapers, magazines, TV,
and radio stations had recently been sold for and ?gured that the
Post was worth $21 a share.
A daily newspaper that has no major competition from another
daily, Buffett believed, enjoys a keen edge. People get accustomed to
the newspaper and its columnists; they are unlikely to switch to an-
other newspaper, even if its price is a nickel or a dime less. Newspa-
pers, after all, are relatively cheap to buy and put out; it is the
advertising that supports papers.
Under capable leadership (remember the Watergate reporting?),
84 BUY WONDERFUL COMPANIESthe Washington Post Company blossomed. Between 1972 and 1998,
sales compounded at 9.1 percent a year and sales per share at 11.8
percent. Earnings per share soared 15.5 percent a year, from $0.52 to
$21.90. The stock’s price-earnings ratio expanded from 7.7 in 1972 to
26.4 in 1998, rising from $4 a share in 1973 to $578 a share at the end
of 1998. The compounded increase in the stock’s price over 25 years
was 22 percent.
Coca-Cola
When news reports announced that Buffett had purchased 6.3 per-
cent of the stock of Cola-Cola, some people were puzzled. In 1989
the stock seemed overpriced—and it was certainly not something
Ben Graham would have bought. Buffett had acquired the stock in
1988 and 1989 at an average price of $43.85 a share. That was 15.2
times the 1988 earnings per share of $2.88.
It was a big bet. Coke then represented 32 percent of Berkshire’s
stockholder equity (as of the end of 1988) and 20 percent of Berk-
shire’s stock market valuation.
Still, Coke is the best-known brand name in the world and the
world’s largest producer and marketer of soft drinks. It sells
almost half the soft drinks consumed on the entire planet, in al-
most 200 countries, and easily outsells its main competitor, Pepsi-
Cola. Best of all, it still has a tremendous number of potential
customers abroad.
Coca-Cola, Buffett said, was a stock he could comfortably hold
onto for 10 years. In talking about Coke, he even evoked one of his
favorite words: “certainty.”
“If I came up with anything in terms of certainty,” he has said,
“where I knew the market was going to continue to grow, where I
knew the leader was going to continue to be the leader—I mean
worldwide—and where I knew there would be big unit growth, I just
don’t know anything like Coke.”
Coke clearly had a moat around it—a moat ?lled with a certain
carbonated beverage. Its 1997 after-tax pro?ts per serving were
less than half a cent, or just 3 cents from a six-pack of Coke.
Yes, there are competitors—beyond just Pepsi-Cola; but com-
peting against Coke on price, taste, and marketing is not a win-
ner’s game.
Coke boasted in 1989 that it would require more than $100 bil-
lion to replace Coke as a business. Commented Buffett, “If you
gave me $100 billion and said take away the soft drink leadership
BUY WONDERFUL COMPANIES 85of Coca-Cola in the world, I’d give it back to you and say it can’t
be done.”
At the end of 1998, Coke’s price (adjusted for splits) was $536,
or 47.2 times 1988 earnings per share of $11.36. The price-earnings
ratio had expanded from 15.2 in 1988 to 47.2 in 1998. From 1988
to 1998, an investment in Coke returned around 28.4 percent a
year.
In recent years Coke has suffered: troubles in Europe, a strong
dollar. The p-e ratio recently was only 38.9. In 2000 the price sank to
$42—and it hadn’t been that low since 1996. Still, in 2001 most of
Coke’s troubles seem to be past, and Value Line was predicting a
brisk pickup in pro?ts. “Coke is still an extremely strong company,
with one of the world’s best-known brand names and considerable ?-
nancial strength,” wrote Value Line’s Stephen Sanborn, “and its
longer-term prospects are favorable.”
As a stock, it sounds like one that Warren Buffett might buy.
American Express
Tweedy, Browne, the investment adviser, boasts that it invested in
American Express a year or two before Buffett himself bought
shares. Yet, ironically, Chris Browne has written that Tweedy,
Browne’s investment was the result of a “Buffett 101” type of com-
petitive analysis.
In the early 1960s American Express seemed to be on the ropes. A
keen competitor, the Visa card company, was running ads showing
owners of fancy restaurants who had announced that they had
stopped accepting the American Express card. (The American Ex-
press card is a “travel and entertainment” card. Cardholders are ex-
pected to quickly pay what they have charged; they pay a yearly fee.
American Express itself assesses stores a higher percentage on
items charged than credit cards do. Visa cards are credit cards. Its
cardholders have free time before they must pay what they owe.
Originally, there was no yearly fee for credit cards.)
American Express had also become involved in a sordid salad–oil
swindle. A subsidiary owned a warehouse in Bayonne, N.J. In the
early 1960s the warehouse began receiving tanks of vegetable oil
from a company called Allied Crude Vegetable Oil Re?ning. The
warehouse gave Allied Crude receipts for the vegetable oil, which
the company used as collateral to obtain loans.
Then Allied Crude ?led for bankruptcy. And the creditors tried to
get the collateral, the vegetable oil in those tanks. Alas, there wasn’t
86 BUY WONDERFUL COMPANIESmuch oil in those tanks. It was mostly seawater. The whole thing had
been a fraud; someone—Anthony De Angelis, by name, who later
went to jail—had bet heavily on vegetable oil futures and lost. Some
$150 million was owed to creditors.
American Express had actually done nothing wrong. Still, to pro-
tect its name, the company magnanimously agreed to absorb the
losses. The company, which had not omitted a dividend payment in
94 years, was rumored to be on the verge of bankruptcy.
“The news about American Express was terrible,” Tweedy,
Browne has written. The stock’s price had dropped to nine or ten
times earnings—and earnings might decline.
The essential question, as Tweedy, Browne saw it, was whether
the American Express card remained competitive.
It was a situation where success bred success, failure bred failure.
If more people used the card, and asked businesses if they accepted
the card, more restaurants and other companies would accept it; if
more restaurants and other companies accepted it, and put the no-
tices on their windows, more people would use it.
But if fewer businesses accepted the card, fewer people could use
it—and even fewer businesses would accept the card.
Now, Tweedy, Browne reasoned, a $100 dinner tab may cost a
restaurant $10 for the price of the food. Gross pro?t: $90. That is be-
fore the cost of the cooks, waiters, rent, insurance, taxes, and so
forth. American Express was charging restaurants 3.2 percent of the
tab, or $3.20. Visa was charging only 1.75 percent, or $1.75.
Would a restaurant be willing to lose a little money in return for
the big bucks that accompanied the American Express card?
Business customers favored the American Express card. Would
restaurant owners fear that these patrons in particular might by-
pass their restaurants if they didn’t welcome American Express
cards?
Many American Express cardholders also had Visa cards, of
course. But few businesses gave their employees Visa cards for
their expense accounts. American Express had 70 percent of
the corporate expense-account market. “The only corporate card
in most persons’ wallets was the American Express corporate
card.”
Tweedy, Browne did a small telephone survey of the restaurants
patronized by one of its managing directors. Would these restaurants
stop accepting the card? A restaurant in Lambertville, New Jersey
had stopped accepting the card. The management had then noticed a
BUY WONDERFUL COMPANIES 87decline in business-related dinners. Management promptly changed
its mind. “We heard the same kind of thing in talking to other busi-
ness owners,” Tweedy, Browne reported.
So, one question had been answered: American Express wasn’t
about to be kicked out of restaurants all over America.
The next question was: Was there a moat around American Express?
Or would Visa and MasterCard move into the corporate expense-
account business?
Tweedy, Browne decided that they would be “somewhat reluctant
competitors in the business credit card ?eld” because of the eco-
nomics of the situation.
The pro?ts that banks make on Visa and MasterCard mainly come
from charging sky-high interest rates on their customers’ unpaid
bills. If Visa and MasterCard customers paid off their debts in time,
they would owe nothing—and wouldn’t be especially desirable cus-
tomers.
If Visa and MasterCard pursued the corporate expense-account
business, these businesses, Tweedy, Browne assumed, would
not tolerate having their employees charged sky-high interest
rates.
“Thus, it seemed to us that American Express’s dominant corpo-
rate-card position was a linchpin, a big moat that ensured accep-
tance of The Card by business establishments, and thereby
protected American Express’s economic castle.”
Beyond that, Tweedy, Browne learned that:
•Cardholders had a higher opinion of American Express cards
than credit cards; it had more cachet.
•Cardholders also considered American Express the more virtu-
ous card because the balance had to be paid off every month,
and there would be no interest charges to pay. If you needed a
quick loan, Visa or MasterCard was what you used. “Even
though an individual can pay off his or her Visa or MasterCard
balance each month and never incur interest charges, several
individuals we spoke with did not think of it this way. Here was
more moat.” And, of course, the moat the merrier.
•American Express, which was behind in its Frequent Flier pro-
gram, was about to catch up.
•Corporate accounting departments found the American Ex-
press statements they received easy to understand and easy to
work with.
88 BUY WONDERFUL COMPANIES•American Express gave some businesses that used its card
special breaks on its travel business, such as discounts. “More
moat.”
In short, by doing some “Buffett 101” type of qualitative research,
Tweedy, Browne got a beat on buying American Express stock.
Its de?nition of that kind of research: “Trying to see the whole pic-
ture, all of the moving parts and how they interact and affect each
other, not just one piece of the puzzle.”
BUY WONDERFUL COMPANIES 89CHAPTER 14
Hire Good People
After some ... mistakes, I learned to go into business only with people whom I like,
trust, and admire. As I noted before, this policy of itself will not ensure success: A
second-class textile or department-store company won’t prosper simply because its
management are men that you would be pleased to see your daughter marry. However,
an owner—or investor—can accomplish wonders if he manages to associate himself
with such people in businesses that possess decent economic characteristics.
Conversely, we do not wish to join with managers who lack admirable qualities, no
matter how attractive the prospects of their business. We’ve never succeeded in making
a good deal with a bad person.
—Warren Buffett
A
“bad person” in this context is anyone who isn’t wholeheartedly
working on behalf of his or her shareholders, the real owners of
the business. Someone whose mental energies are concentrated on
his or her own ?nancial well-being, his or her next job, or his or her
future comfortable retirement.
The ideal people that Buffett wants in the way of management are
people who behave as if they themselves were the owners. He wants
them to be fanatics—to work their heads off, to live, breathe, and eat
the business. And, of course, to be capable, and there’s no better evi-
dence of that than they have already been running the business and
boosting the business’s cash ?ow.
Of course, the ordinary investor is not in a position to check out
the quality of management as thoroughly as someone like Buffett.
But the ordinary investor can read the annual reports; attend annual
meetings; read pro?les of management people in BusinessWeek,
Fortune, and Forbes, and perhaps see interviews with them on tele-
vision. Granted, mistakes may be made. I myself was very much im-
pressed after interviewing Lucent’s former chairman at a
shareholders’ meeting before Lucent all but dropped off the face of
the earth. But I was also so impressed by hearing the chairman of
Johnson & Johnson talk (he criticized his company as well as him-
self) that I bought more shares.
91The management of a company cannot work miracles. Or, as
Buffett has nicely put it, “I’ve said many times that when a manage-
ment with a reputation for brilliance tackles a business with a rep-
utation for bad economics, it is the reputation of the business that
remains intact.”
But good managers can work near-miracles. They can develop a
sensible plan and a reasonable timetable. Like top money managers,
they can sit down with a ?ood of information, some con?icting, and
decipher the fundamental trends and the most reasonable course of
action. They can make logical decisions and get things done. They
can improve morale. Reward competence. Cajole and persuade peo-
ple. Look out for the company’s best interests instead of just looking
out for themselves.
Ron Baron, the fund manager, tells of buying stocks to a large ex-
tent simply because he was so con?dent in the new management.
One manager had taken a failing hospital system and, astonishingly,
turned it around; he then took over another hospital system in trou-
ble. Investing in him, and the hospital, was, in Baron’s view, almost a
slam dunk. Mario Gabelli, another well-known fund manager, has
put up on his of?ce walls blown-up photographs of executives who
had turned their companies around—while, of course, Gabelli funds
owned their stocks.
Some other signs that the management of a company warrants
respect:
• They may buy back shares when the price seems low. This en-
courages investors (even management, clearly, thinks the price
is low); it reduces shares outstanding, thus helping favor de-
mand over supply. (Alas, many companies announce share buy-
backs—and never do it. And some buy back shares even when
they’re not especially cheap.)
• They are cost-conscious, up and down the line. I once asked a
corporate executive whether it’s really important how conscien-
tiously an employee ?lls out his or her expense account. Does
the company really care if an employee takes a cab or public
transportation? Dines at a ?ve-star restaurant, with over?owing
wine, or eats in his or her hotel room? Stays at the Ritz or a per-
fectly decent motel? His answer: “How an employee spends the
corporation’s money through his expense account indicates
how he’ll spend greater amounts of the corporation’s money if
he ever is given the opportunity.”
• They are forthright. Like Berkshire itself. Buffett has told his own
shareholders, “We will be candid in our reporting to you, empha-
92 HIRE GOOD PEOPLEsizing the pluses and minuses important in appraising a business.
Our guideline is to tell you the business facts that we would want
to know if our positions were reversed. We owe you no less.”
• They act like owners. In some cases, because they were once
the owners. They are obsessed with their businesses.
• They are scrupulously fair. Time and again, Buffett has re-
minded his shareholders that Berkshire is punctilious about
dealing with them honorably. Unlike other companies, which
(before the Securities and Exchange Commission issued a regu-
lation on the subject) tipped off their favorite analysts and
clients about developments that they had not told their own
shareholders, Buffett has no favorites. “In all our communica-
tions,” he wrote, “we try to make sure that no single shareholder
gets an edge. We do not follow the usual practice of giving earn-
ings ‘guidance’ to analysts or large shareholders. Our goal is to
have all our owners updated at the same time.”
HIRE GOOD PEOPLE 93
Hire Warren Buffett
Warren Buffett runs Berkshire Hathaway by practicing what he preaches:
•For years he and Charlie Munger have been paid very low salaries,
especially for heads of a Fortune 500 corporation. “Indeed,” commented
Buffett, “if we were not paid at all, Charlie and I would be delighted with
the cushy jobs we hold.”
•He and Munger eat their own cooking; most of their money is in Berkshire.
“If you suffer, we will suffer; if we prosper, so will you. And we will not
break this bond by introducing compensation arrangements that give us a
greater participation in the upside than the downside” (via stock options).
•When Berkshire split into A and B shares, Buffett told shareholders,
“Berkshire is selling at a price at which Charlie and I would not consider
buying it.” That is like Joe Torre disparaging the chances of the Yankees
winning the pennant: “Our ballplayers are too old and too rich.” But Buffett
wanted to be fair with potential Berkshire buyers. So he also used the
occasion to point out that the brokers’ commissions on the B shares would
be only 1.5 percent—extraordinary for an initial public offering.
•Berkshire is probably the only corporation that lets its shareholders (A
types) designate where they want Berkshire charity money to go. Why
should corporate executives send all the money to their own alma maters?
•Berkshire shareholders don’t pay taxes on dividends the company receives
from companies like Coca-Cola and Gillette; Berkshire pays them.People Buffett Has Admired
All the businesspeople whom Buffett has admired seem to have
emerged from the same Ebenezer Scrooge-like mold. They remind
one of the Jean Cocteau ?lm in which a young man keeps falling in
love with women with the same face. (Much of the information that
follows comes from Roger Lowenstein’s biography, Buffett: The
Making of an American Capitalist, New York: Doubleday, 1995.)
•Buffett’s grandfather, Ernest, would lecture 12-year-old Buffett
on the virtues of hard work when the young man helped out in the
family grocery store. Ernest would also deduct two cents from his
grandson’s salary, just to convey to him the onerousness of govern-
ment taxes.
•The legendary Rose Blumkin could not write and could barely
read. She was born in Russia and lived in poverty—she and seven
brothers and sisters slept in one room. Her family came to the
United States in 1917, then settled in Omaha in 1919. She began sell-
ing furniture out of her basement, and eventually—in 1937—rented a
storefront and started Nebraska Furniture Mart. Her motto: “Sell
cheap and tell the truth.”
She worked every day of the year. Never took a vacation. She
screamed at her staff (“You dummy! You lazy!”). Her store was a
huge success. Her explanation: “I never lied. I never cheated. I never
promised I couldn’t do. That brought me luck.”
A local paper asked her what her favorite ?lm was. “Too busy.”
Her favorite cocktail? “None. Drinkers go broke.”
Her hobby? Driving around and checking what other furniture
stores were selling and for what prices.
Buffett, who bought Nebraska Furniture Mart, called her one of
his heroes.
•Ken Chace had been chosen by Buffett to run Berkshire Hath-
away, the textile mill. He never knew why—until the day he re-
signed. Then Buffett told him, “I remember you were absolutely
straight with me from the ?rst day I walked through the plant.”
•A self-made man, Benjamin Rosner, owned Associated Cotton
Shops, a chain of dress shops, which Buffett bought in 1967. Rosner
was a work addict and, toward his employees, a slave driver. He
once counted the sheets on a roll of toilet paper he had bought, just
to make sure he had not been cheated.
•Jack Ringwalt was the majority owner of National Indemnity, an
insurance ?rm in Omaha, which Buffett eventually bought. Ringwalt
had entered the business during the depression by insuring risks that
his competitors didn’t want to touch, such as insurance for taxicabs,
94 HIRE GOOD PEOPLElion tamers, and bootleggers. Like Buffett himself, he actually was
risk averse. “There is no such thing as a bad risk. There are only bad
rates,” he told Buffett. (If you charge enough, you can remove the
gambling aspect from something that’s seemingly risky.) When Ring-
walt went out to lunch, he left his coat in the of?ce even in winter—
just so he wouldn’t have to check it and pay a charge.
•Eugene Abegg ran Illinois Bank & Trust in Rockford, Illinois. He
had taken over the failing bank during the depression, and through
intensely hard work built it into $100 million in deposits.
•Thomas S. Murphy, head of Capital Cities/ABC, saw to it that the
giant company had no legal department and no public relations de-
partment. He was so frugal that when he had his headquarters
painted, he didn’t paint the side that no one could see, the side that
faced the river. When he took over ABC, he closed the private dining
room at the New York City headquarters.
•Roberto C. Goizueta of Coca-Cola had been buying back stock
with excess cash. He also insisted that his managers account for the
return on their capital.
•Carl Reichardt, chairman of Wells Fargo, the San Francisco
bank, had sold the company jet and frozen the salaries of the other
top executives during bad times. And he avoided real risks, like mak-
ing loans to Latin American countries.
PEOPLE BUFFETT HAS ADMIRED 95CHAPTER 15
Be an Investor,
Not a Gunslinger
The stock speculator who cannot keep even the best of stocks for more than a few days
because he does not get any ‘action’ out of them, that is, because they do not rise
immediately in price, is a pitiable object. He often needs as much sympathy as the
hopeless drunkard, the drug addict, or the cripple.
I have known speculators who had bought stocks which everyone knew were certain
to appreciate in value and which in the course of a few months or even a few weeks did
rise considerably, and in many cases increasing their dividend payments. But just
because the stocks did not go up within a few days after they had been acquired the
speculators became disgusted with them and let them go.
—Albert W. Atwood, Putnam’s Investment Handbook, 1919
O
ne explanation of Buffett’s extraordinary success as an investor is
that he, along with most other value investors, resists the tempta-
tion to be a gunslinger. He doesn’t continually buy and sell. He buys
to hold—and buys and holds.
Berkshire is not just risk averse. It’s activity averse.
Said Buffett, “As owners of, say, Coca-Cola or Gillette shares, we
think of Berkshire as being a nonmanaging partner in two extraordi-
nary businesses, in which we measure our success by the long-term
progress of the companies rather than by the month-to-month move-
ment of their stocks. In fact, we would not care in the least if several
years went by in which there was no trading, or quotation of prices,
in the stocks of those companies. If we have good long-term expec-
tations, short-term price changes are meaningless for us except to
the extent they offer us an opportunity to increase our ownership at
an attractive price.”
When Buffett buys a stock, his favorite holding period, he has fa-
mously said, is forever. He has confessed that he makes more money
by snoring than by working.
Before buying a stock, he asks himself: Would I want to own this
97business for 10 years? He doesn’t slavishly follow the stock ratings
in Value Line or Standard & Poor’s. Those ratings are for only one
year, not 10 years. And he stalwartly resists the vast conspiracy out
there to get investors to buy, buy, buy, and to sell, sell, sell.
Chris Browne of the Tweedy, Browne funds has noted that Coca-
Cola might not be a good buy right now. But if someone were asked
to compile a list of stocks almost certain to do well over the next 20
years... .
There are other sensible and pro?table ways to invest, of course,
besides buying good companies and holding on. But for the lesser
investor, buying good companies and just hanging in there is not
impossibly dif?cult and challenging—and the tax bene?ts are noth-
ing to sneeze at either. Buying good companies and tenaciously
holding on doesn’t require the accounting knowledge of a CPA, the
investment knowledge of a CFA, or the up-to-the-minute informa-
tion of an analyst. Just buying the Dow Jones Industrial Average is
a sound and simple way for the lesser investor to do well—granted
that this index, like others, every once in a while kicks out disap-
pointing companies.
The Bene?ts of Sitting Still
Most investment strategies bene?t when their managers buy and sell
less frequently. For these reasons, among others:
•Value managers tend to stand pat; when growth managers play
cards, they are always saying, “Hit me.” Growth managers may have
a harder time because they must make more frequent decisions.
•A high turnover means higher commission costs.
•A high-turnover portfolio is linked with low tax-ef?ciency
(your gains are not shielded from Uncle Sam, which they would be
if you held on). This isn’t invariable. A manager whose portfolio has
a high turnover may deliberately offset gains with losses, to boost
tax-ef?ciency.
Over time, despite the experience of recent years, value stocks have
done better than growth stocks—although this has been vigorously
disputed in certain quarters. It can be tricky to de?ne value stocks
and growth stocks, and to decide when growth stocks cease to be
growth stocks and value stops being value; the time period you
study can also in?uence the outcome.
In any case, if value stocks do better in the long run, it may be sim-
ply because they tend to pay higher dividends. George Sauter, who
runs the Vanguard index funds, believes that once taxes are taken
98 BE AN INVESTOR, NOT A GUNSLINGERinto consideration, growth and value do the same. John Bogle, who
founded the Vanguard Group, also believes that, in the long run,
growth and value will come out even.
Another view is that it takes more courage, more sophistication,
and more self-con?dence to be a value investor. That’s why some ob-
servers are convinced that most lesser investors are growth ori-
ented; most professionals are valued oriented. (It’s true that
professional money managers like to talk like value investors: Their
clients want to hear the value story, to be told how averse their
money managers are to losing money.)
So it may be that value managers are rewarded more generously
because they deserve to be better rewarded. The more pain, the
greater the gain.
Why Investors Become Gunslingers
Many investors, especially unseasoned ones, buy and sell almost
with the abandon of men switching television channels with their re-
motes. Buffett has referred to this as a “gin rummy managerial style,”
where you keep drawing new stocks, holding some for a while,
quickly discarding others. Fast, furious, and—no doubt—fun.
In 1999 investors in general kept their stocks for an average of
eight months, down from the two years that investors had kept
stocks ten years earlier. Investors held Nasdaq stocks (generally
smaller companies, along with technology issues) for only ?ve
months, down from two years. Even mutual fund investors are keep-
ing their shares for fewer than four years versus eleven years a
decade ago.
In a well-known study of 60,000 Charles Schwab investor–house-
holds from 1991 to 1997, Brad Barber and Terrance Odean, profes-
sors of management at the University of California at Davis, found
that households that traded the most earned an annualized net re-
turn of 11.4 percent, while those who bought and sold infrequently
earned an impressive 18.5 percent.
Beyond that, an April 1999 study of 10,000 individual investors by
Odean found that the stocks that were bought to replace the stocks
that had been sold performed worse. Investors lost 5 percent of their
money on these trades (commission costs included).
The fact that momentum investing as an investment strategy has
been so popular in recent years is perhaps the result not only of a
prosperous economy and a soaring stock market, but of the greater
number of ordinary investors who participate in the stock market.
More Americans now own stocks than ever before. Also, online trad-
WHY INVESTORS BECOME GUNSLINGERS 99ing has lowered the commissions that investors must pay and made
it easier to trade.
Lesser investors may buy a stock for the ?imsiest of reasons. Be-
cause it’s fallen far from its high. Or somebody on the TV series Wall
$treet Week has just recommended it. Or—most commonly—be-
cause the stock has been going up.
“Momentum” investing—buying what’s hot—is what beginners do.
If you assembled a group of children, or inexperienced investors in
general, and asked them which stocks they would choose, they
would surely answer: stocks that have been doing well lately. Buying
hot stocks, in short, is normal.
People tend to repeat whatever has been successful in the past; to
bet on whatever has been working. We extrapolate. Extrapolation is
generally a wise strategy. If we like a particular food or restaurant,
we will return to that food or restaurant; if a friend proves a friend in
need, we will seek his or her help again. Objects in motion, as Sir
Isaac Newton observed, tend to remain in motion.
So, when we turn from investing in CDs and money market funds
to investing in stocks, we naturally choose to buy stocks on a tear,
the favorites. Warren Buffett has pointed out that if we were buying
a loaf of bread or a bottle of milk, we would buy more when the
price went down. If the price went up, though, we would buy less, or
shop elsewhere. Why don’t we do that with stocks? Why aren’t more
of us value investors?
The answer is: because we’re not consuming those stocks we buy;
we’re planning to resell them, at a still higher price. Quickly. If we
were buying stocks to hold for 10 years, as Buffett recommends, we
might buy more of them as their prices went down, and less as their
prices went up.
More Explanations
If the general public is indeed more growth oriented than value ori-
ented, further explanations are easy to ?nd.
•Beginning investors are typically not aware that buying a va-
riety of blue-chip stocks, especially when they’re a bit off their feed,
is a sound, conservative investment strategy. It won’t prove to any-
one that you’re smart, resourceful, or imaginative. But it’s a sensible
way to go if you want to retire rich.
A lawyer specializing in wills and estates once told me that
when he examined the assets of well-to-do people who had re-
cently departed, he found that many had bought stocks like Coca-
100 BE AN INVESTOR, NOT A GUNSLINGERCola, Merck, Exxon, and General Electric in their 20s—and hung
on and on.
Studies of self-made investment millionaires con?rm that they
tend to be buy-and-hold investors. Charles B. Carlson, author of
Eight Steps to Seven Figures (New York: Doubleday, 2000), reports
that “The majority of millionaires surveyed hold stocks for at least
?ve years. Many hold for ten years or more.” (He interviewed more
than 200 such people.)
• Young people tend not only to buy hot stocks; they tend to trade
them faster, too.
Partly it may be on account of their metabolism. Your body slows
down as you age; you yourself probably become more conservative,
more worried about possible injury.
Then, too, it may be that as we grow older, life sometimes be-
comes more complex and dif?cult; our portfolio has swollen, our
sources of income are varied, our pension plans are all over the
place, we’ve had any number of jobs (and spouses)—it’s hard to
keep track of everything. Form 1040EZ is a thing of the distant and
loving past. Besides, you want your survivors to have an easy time
cleaning up the mess you left. Not to mention the erosion of your
IQ points, making it dif?cult for you to track so many different
investments.
The young may also not know that it can take a while for other in-
vestors to wise up and recognize a good company for what it’s really
worth. You can buy a stock for $20, knowing it’s worth $40, and
watch it retreat to $10 and stay there. (Fortunately, when it’s ?nally
recognized, it may shoot up like a rocket.)
The point is that if you’re right, you’re right. The fact that a
stock you bought, which you thought was a screaming bargain,
then went down and stayed down for a while, is not proof that you
made a mistake.
No one, of course, should “?ght the tape”—refuse to accept the re-
ality of what a stock or the stock market is really doing. But viewing
the tape with skepticism is sometimes a wise course. The problem is
that beginning investors may not have the experience, or the self-
con?dence, to recognize that the stock market’s day-to-day judg-
ments are not always infallible. Perhaps because they believe in the
ef?cient market hypothesis.
•Another reason people trade so much: They bring along the
habits they developed from gambling, from betting on baseball
teams, football teams, horse races, and—above all—card games,
MORE EXPLANATIONS 101like poker, which some people claim to be the true national pastime.
And when we gamble, we tend to put money on the previous win-
ners. The race is not always to the swift, the battle to the strong,
commented Damon Runyon, the newspaperman, but that’s the way
to bet. To bet on the tortoise, you would want towering odds.
• By the same token, value investing is more sophisticated,
more advanced. The beginning investor doesn’t normally think of
betting on dark horses, on fallen angels, on the walking wounded. It
takes thought, experience, and education to know that investing in
companies in hot or at least lukewarm water can be pro?table and
relatively safe. Is the ?rst stock anyone buys a value stock?
It takes a person some investment experience, or education, to
learn that it may be better to buy a decent company at a low price
rather than a glamorous company at a very high price. And that even
the stocks of glamorous companies can be vastly overpriced, while
struggling companies can be cheap and the better buy. (But strong
companies in general do deserve some extra points.)
True, value investing, can prove to be anything but roses and wine.
Other investors look askance at you (“You bought—what?”); your
boss may question you sharply; and if you’re a money manager, your
shareholders may throw poisoned darts in your direction. Chris
Browne of Tweedy, Browne, who writes an erudite and witty quar-
terly report, recalls receiving a letter from a shareholder accusing
him of spending so much time writing his reports just to disguise
how poorly his fund had been doing lately. (The fund rebounded
nicely after 1999.)
• Human beings tend to stress the short-term, to emphasize
what has happened recently. Politicians take tough, unpopular steps
in their ?rst year of of?ce—raising taxes, say—and count on the last
three fat years to bail them out. In the last year, in fact, they may go
on a hiring binge and cut taxes. We concentrate on what’s been hap-
pening in the stock market in recent months and years, but either ig-
nore or don’t know what happened years ago.
So it’s easier for most people to buy hot stocks, stocks on a tear,
rather than to do something so peculiar as to bet on unpopular,
widely despised stocks.
• Do investors buy and sell quickly because of lack of
con?dence? They bought American Antimacassar for the ?imsiest of
reasons, and now that it has gone nowhere, they may have little con-
?dence in their original judgment. Perhaps they bought it on a maga-
zine’s recommendation. And if they were more familiar with the
102 BE AN INVESTOR, NOT A GUNSLINGERstock, and had a number of good reasons for having bought it in the
?rst place, they might not get so antsy. (Value investors, who tend to
know their stocks thoroughly, are tempted to buy more shares when
the price goes down.)
As a matter of fact, there’s evidence that people in general, and
investors in particular, tend to be too con?dent. Around 80 percent
of the drivers in Scandinavia (or anywhere else, I’m sure) think
that they’re above average—when only 50 percent can be above av-
erage. Tests on U.S. citizens ?nd that, given general questions to
answer, they think their answers are correct far more often than
they really are.
“Investors have become overcon?dent about their prowess in
choosing stocks that will go up,” observes Patricia Q. Brennan, a ?-
nancial professor at Rutgers University in New Brunswick, New Jer-
sey. “They attribute the good returns to themselves, the bad ones to
their advisers, rather than to a stock market that has been rising.
One of the results of this overcon?dence is that they underestimate
the risks they are taking.”
But if investors are overcon?dent, why do they sell stocks to buy
other stocks? Maybe they have gains on the stocks they sell, sug-
gests Chris Browne. Or maybe they don’t sell their losers and simply
keep buying new stocks. That would help explain why so many peo-
ple wind up with “messy portfolios,” a huge, unwieldly godawful
grab bag of this and that.
In the Odean study, men didn’t fare so well at investing as
women, presumably because men trade too frequently. Women hold
their stocks longer, perhaps because they simply lack the con?-
dence that men have—another uplifting example of modesty’s being
rewarded. A supplementary explanation is that this has something
to do with the male and the female roles. Men historically spent
more time outside the home, exposed to the elements and vulnera-
ble to all sorts of dangers. Perhaps a need to continually move
around, to avoid the elements and to avoid becoming prey, was bred
into their genes.
Trading, in fact, seems more masculine. We have many words in
praise of active, energetic, dynamic people; many other words den-
igrate those who are lazy and slothful. Idle hands are the devil’s
playthings.
Growth investing, with its quick ups and downs, is more exciting,
more interesting. Gin rummy, after all, does have its good points.
Many people are in need of novelty. That’s why we have cycles in so
many areas of human endeavor. Sociobiology is popular; then it
fades; then it returns to favor. Technology stocks are the new thing;
MORE EXPLANATIONS 103then investors lose interest; then they rebound. Growth and value in-
vesting alternate days in the sun.
Enthusiastically showing me his collection, a child I know, Kevin,
was enchanted with Pokemon cards a few years ago. Then he turned
his back on them. “They’re for little kids,” he said, disgusted.
An ancient Greek explained why he was the only resident of his
town not to vote for Aristides the Just: “I was tired of hearing him al-
ways called Aristides the Just.”
Also, Chris Browne has noted that it’s hard for “energetic, intelli-
gent, well-educated, highly paid and self-con?dent individuals
[money managers in general] ... to sit tight and do nothing.” Even
though the evidence is that index funds, which rarely change their
holdings, outperform most managers who spend their days shuf?ing
their deck of stocks.
Buying and selling gives these people, Browne claims, “the illusion
of control.” They think they are doing something worthwhile, that
they are “in charge.”
“Why would investment management ?rms want to pay high
salaries to people who do not appear to be doing very much, and
who do not appear to have much control over what they are doing?
Investment management ?rms, in general, must believe that lots of
activity is useful because they are willing to pay for it, and high com-
pensation ensures that lots of activity will be provided. Everyone in-
volved must believe that it all makes sense.”
Being a value manager and sitting still may be interpreted as lazi-
ness. The manager of Vanguard Windsor II, James P. Barrow, once
told me, perhaps somewhat seriously, that he feels guilty getting
paid to do so little. Doesn’t your boss want you always to be work-
ing? Doesn’t your boss love it if you work through lunch hour—as-
suming he or she gives you a lunch hour?
Another reason Browne furnishes for all this hyperactivity: Too
many investors and institutions, when they judge a money manager’s
performance, don’t pay enough attention to after-tax returns. If it’s a
tax-favored investment, that’s another story. But estimates are that
60 percent to 70 percent of money invested in stocks is owned by
tax-paying people and corporations. And buying and selling tends to
increase taxes you owe.
Besides, there are a lot of good mutual funds out there, and buying
more and more of them can be dif?cult to resist. The same is true of
stocks. There are wonderful companies out there, and don’t they de-
serve a place in your portfolio along with those excellent stocks you
already own? Still, as Buffett has pointed out, if you let a fat pitch
cross the plate and you don’t swing, there’s no umpire to call a
104 BE AN INVESTOR, NOT A GUNSLINGERstrike. Why did he say that? Because we tend to feel that we must
swing at fat pitches—and buy all the good stocks.
A good rule is: You don’t have to buy every good stock, or every
good mutual fund, or marry every attractive woman (or man).
• There are economic reasons for having investors trade fre-
quently. Stockbrokers are paid by commissions, and the more their
clients trade, the more money they make.
Bob and Rosemary Bleiler of Paramus, N.J., wanted to buy Disney
stock many years ago, after they visited Disney World. The young
broker they sat down with discouraged them—but then “permitted”
them to buy 50 shares instead of the 100 they originally wanted. The
stock did very nicely. Six months later, the young broker phoned. It’s
time to sell, she told them. Lock in your pro?ts. They were reluctant.
“That’s what you do—you get in and you get out,” she told them.
What she didn’t tell them was that they were celebrating after hav-
ing made goodly pro?t, but she was just a wall?ower at their party.
She couldn’t join in the festivities unless they sold—and paid her a
second commission when they bought something else. (Had they
bought 100 shares of Disney then and kept it, the Bleilers calculate,
they would have made $37,000.)
• Wall Street analysts also foster a gin-rummy investment cli-
mate. While they may be reluctant to issue a sell recommendation,
they focus on whether a company they cover will meet its quarterly
earnings estimates, and whether or not it will outperform over the
next year. Analysts, like money managers, are expected to justify
their salaries—in their case, by producing important, hard news.
So are the media, which continually convey a ?ood of the latest
business news, all of it worth knowing, much of it worth ignoring.
But if a CNBC announcer reports that one analyst has changed his or
her rating of American Antimacassar from “buy” to “hold,” the impli-
cation is that you should do something about this vital piece of infor-
mation. “All the noise that Wall Street produces,” money manager
Michael Price once said to me disgustedly.
Newspapers must have big headlines to balance small headlines,
so some stories get played up. Financial programs on TV and radio
must ?ll up their time. Besides, overplayed sensational stories get
better read. We journalists don’t play up stories just to sell newspa-
pers, as critics contend. We overplay stories to get them read. A very
human desire, especially common among writers.
Journalists also want to be read continually. A newsletter editor I
know changes his recommendations of mutual funds every so often,
MORE EXPLANATIONS 105so readers will inevitably conclude that they cannot dispense with
his newsletter. Otherwise, they would miss his vital buy-and-sell
decisions.
Forbes magazine changes its honor roll of best mutual funds so ex-
tensively every year that its portfolio has done rather poorly. Chang-
ing funds once a year, on an arbitrary date, is not sound investment
strategy. But if the honor roll remained virtually the same every year,
how eager would readers be to see it?
The agreed-upon wisdom in the media seems to be that investors
should quickly lock in good stocks—and quickly get rid of deterio-
rating companies. They probably should—if they are growth in-
vestors. And the media focus on growth investors. Not sophisticated
growth investors, but unsophisticated growth investors.
Even a newsletter that Warren Buffett himself reads, the “Value
Line Investment Survey,” caters to traders. It focuses on how a stock
may perform over the next year.
In the January 12, 2001, issue of “Value Line,” three of the 100 most
timely stocks were removed because their earnings declined relative
to other companies’ earnings, and three others—with growing earn-
ings—replaced them. Of the 300 second-most-timely stocks, there
were 16 changes.
Whereas “Value Line” is growth oriented, concentrating on stocks
with increasing earnings, Standard & Poor’s “The Outlook” also will
recommend value stocks, stocks of companies that have been suf-
fering but that seem underpriced. Still, even “The Outlook” has a
short-term outlook. In its January 10, 2001 issue, nine stocks were
upgraded (to top rating or second); nine were downgraded; coverage
for ten new stocks was initiated.
Examples of the reasoning behind upgrades: Pittston Company
“will bene?t from a greatly improved environment in which to divest
the company’s coal operations.” eBay “will see greater relative activ-
ity in a slowing economy as buyers seek better deals and sellers
want to raise money.” Circuit City Stores’ “decision to move more
slowly on store remodeling is a plus.”
The reasoning behind downgrades: Tiffany & Company’s “disap-
pointing holiday season sales and resulting lower earnings estimates
leave shares fairly valued” (down from above average). Park Place
Entertainment: “Slowdown in U.S. economy could translate into
weaker business for gaming company.”
Still, “Value Line,” in its analyst reports, will sometimes consider
the long-term investor. AptaGroup gets only a 4 (below average) rat-
ing, but the analyst writes: “ ... patient investors might ?nd its 3- to
5-year potential capital gains interesting.” Rock-Tenn Company is
106 BE AN INVESTOR, NOT A GUNSLINGERranked 4: “ ... we think patient investors should consider this issue.”
At the opposite end, a stock rated 2 (above average), Instituform
Technology, has unappealing prospects: “long-term appreciation po-
tential is limited, though, since we expect a somewhat lower, more-
normal price-earnings ratio” in three to ?ve years. Kaufman & Broad
is rated 1, but “given the run-up in the stock’s price, this issue offers
below-average long-term appreciation potential.”
Needless to add, following the stock market intensively can
make investors very nervous. It’s hard to hold onto a stock for 10
years when you are regularly receiving bad news about that stock.
Days when stocks go down are almost as frequent as days when
they go up.
In fact, if homeowners knew what the value of their homes were
day after day, instead of at intervals of many years, perhaps they
would not have hung on so patiently. What if a home had been worth
$250,000 in 2000, then only $225,000 in 2001? Would the homeowner
have sold in a panic?
It’s natural for the media to focus on growth investors, people con-
cerned about the next quarter’s earnings. Those are the people most
interested in the news. Not that value investors aren’t interested in
news, but in less.
What would a newsletter for value investors be like? A virtually
unchanging portfolio with reports on the same stocks again and
again.
One reason Buffett can buy and hold with such equanimity is that
he doesn’t get distracted. He doesn’t care whether the Grand Pooh-
Bah at this-or-that company is talking doom-and-gloom, or that the
Grand Pooh-Bah at that-or-this company is singing “Happy Days Are
Here Again.” He doesn’t guess where interest rates are going now,
speculate about the implications of the trade de?cit, estimate the
economic consequences of a tax cut, fret about what the 60-day
moving averages show, or whether dividend yields are historically
high or historically low or historically average. To quote Buffett,
If we ?nd a company we like, the level of the market will not really impact
our decisions. We will decide company by company. We spend essentially
no time thinking about macroeconomic factors.
In other words, if somebody handed us a prediction by the most
revered intellectual on the subject, with ?gures for unemployment or in-
terest rates, or whatever it might be for the next two years, we would not
pay any attention to it.
We simply try to focus on businesses that we think we understand and
where we like the price and management.
MORE EXPLANATIONS 107•Another reason why people may trade so often: It’s a survival
from earlier times. Even into the twentieth century, many gambling
parlors passed themselves off as brokerage houses. Customers didn’t
actually invest in companies via their stocks. They bet on whether
stocks would go up by a certain number of points. And the bet lasted
only a short time. These gambling parlors were called bucketshops.
“There is no room for doubt as to the character of the bucketshop,”
wrote John Hill Jr. in his book Gold Bricks of Speculation: A Study of
Speculation and Its Counterfeits, and an Expose of the Methods of
Bucketshop and “Get-Rich-Quick” Swindles (Chicago: Lincoln Book
Concern, 1904). “It is a gambling den, and nothing else. It is generally
a dishonest gambling den, for there are few, if any, bucketshops
whose frequenters have fair treatment. The patron puts his money
into the pretended purchase or sale of stocks, grain or other com-
modities, at prices posted on the blackboard, which are, or purport to
be, the ?gures at which securities or commodities are selling on the
?oor of the stock or produce exchanges. He bets that the price will
vary in his favor before it will go one point against him.”
But the bucketshops’ proprietors, while seemingly selling some-
thing like options, actually manipulated the prices so that customers
almost always lost.
“Thus, in de?ance of law and decency, the ‘future delivery’ trans-
actions on grain and cotton exchanges and the cash transactions on
the stock exchanges have been counterfeited in bucketshops, with
disastrous results to the reputation of exchanges and legitimate bro-
kers and commission merchants. ...
“While the whole scheme is one that should call forth public
protest, especially from the agricultural classes [who frequented
bucketshops more], its novelty in a small community where enter-
tainment and excitement are lacking draws all classes to the coun-
terfeit ‘boards of trade.’”
The author, who was with the Chicago Board of Trade, concludes
that “One sometimes wonders if avarice is our national curse.”
These old-time gambling parlors possibly have had some in?uence
upon modern brokerage houses and their practices. Anthropologists
call old practices that continue in a new form “survivals.”
Professional Advice
An unusual stockbroker is Barbara F. Piermont in Florham Park,
New Jersey, who recommends that her clients buy good blue-chip
stocks and hold onto them. A 30-year veteran, she acknowledges
108 BE AN INVESTOR, NOT A GUNSLINGERthat one reason so many other investors buy and sell is that their
stockbrokers want them to—because they are paid through commis-
sions. So is she, but “I don’t live on them. And I have lots of clients,
who are happy to send me more clients.”
She has discouraged her clients from pursuing hot companies, like
the dot-coms. “I like slow and steady stocks, and I want my cus-
tomers to be investors, not traders.”
To persuade her customers not to trade so much, she urges them
to set goals they want to reach. Focusing on the long-term seems to
make people less inclined to gamble in the here and now.
It’s the New Generation, she believes, who trade so much, espe-
cially after normal trading hours, after watching CNBC or the news
headlines. Some hot new stock is touted; they buy it and hold it a
few days; they then suffer buyer’s remorse and unload it. “Quick
money,” she calls it.
Blue chips under a temporary cloud, she suggests, may be good
buys. Or if a blue chip announces good news (higher earnings, the
settling of a lawsuit, a big new contract) and the price unaccount-
ably doesn’t re?ect the news, consider adding that stock to your
portfolio.
A compromise she suggests for some of her clients: Set aside 5
percent to 15 percent of your money for trading, and put the rest in
“stable stuff.” You might use any excess pro?ts from your gambling
portfolio to put into your serious portfolio. But don’t take pro?ts
from your serious portfolio to re?nance your gambling portfolio. (A
mutual fund authority, Alan Pope, has recommended that people
have two portfolios of mutual funds: one for serious money and one
for “crap-shooting money.”)
Where did she get the idea to recommend that her clients buy and
hold blue-chip stocks?
Henry and Phoebe Ephron were writers (Nora Ephron, author of
the novel Heartburn, is their daughter), and at a party Mrs.
Ephron, who knew nothing about investing, happened to meet
Bernard Baruch, the famous investor. (Among investors of the dis-
tant past, he is one of the very few whose writings are still worth
reading. It was Baruch who said, “Buy straw hats in January.” He
confessed that he always sold too soon. He also said that the only
people who buy at the bottoms and sell at the highs are, of course,
liars. Baruch is reported to have told Will Rogers to exit the stock
market before the Crash of 1929, advice for which Rogers was al-
ways grateful.)
At the party, Mrs. Ephron heard Bernard Baruch give someone ad-
vice. Invest in a company that makes a product that people use, then
PROFESSIONAL ADVICE 109throw away, Baruch said. (Baruch once asked Ben Graham to be-
come partners with him, but Graham declined.)
Mrs. Ephron went home and thought about it. Then she went to
bed. In the middle of the night, she woke up with an idea. She had
two daughters. She decided to invest in the company that made
Tampax.
She did. And when she died years later, Mrs. Piermont learned
from a friend, Mrs. Ephron’s thousands of shares of Tampax were
worth a fortune.
“That stuck in my mind,” says Mrs. Piermont. People should buy
companies with products in inexhaustible demand and just hold on.
More from Buffett on Buying to Hold
When Berkshire owns stocks of outstanding businesses with out-
standing managements, Buffett has said, “Our favorite holding pe-
riod is forever. We are just the opposite of those who hurry to sell
and book pro?ts when companies perform well but who tenaciously
hang on to businesses that disappoint. Peter Lynch aptly likens such
behavior to cutting the ?owers and watering the weeds.”
“Lethargy bordering on sloth,” as Charlie Munger once put it, “re-
mains the cornerstone of our investment style.”
Buffett, as he has regularly reminded his shareholders, doesn’t
care what happens to the economy (apart from sometimes allowing
him to buy stocks cheaply) or to the prices of the stocks he owns.
With companies like Coca-Cola and Gillette, “we measure our suc-
cess by the long-term progress of the companies rather than by the
month-to-month movements of their stocks. If we have good, long-
term expectations, short-term price changes are meaningless for us
except to the extent they offer us an opportunity to increase our
ownership at an attractive price.”
On another occasion: “We continue to avoid gin rummy behavior.”
True, Berkshire closed its textile business after 20 years, but “only
110 BE AN INVESTOR, NOT A GUNSLINGER
A Possible Cure
How to cure yourself of trading too much? James B. Cloonan, chairman of the
American Association of Individual Investors, has confessed that “I still sell
stocks too quickly.” His solution: “to maintain an arti?cial portfolio of all
stocks I sell, using the sale price as the purchase price. I then monitor that
portfolio to see how it performs.”because we felt it was doomed to run never-ending operating losses.
We have not, however, given thought to selling operations that would
command very fancy prices nor have we dumped our laggards, al-
though we focus hard on curing the problems that cause them to lag.”
In a famous passage during one annual report, Buffett revealed
that he considered Capital Cities/ABC, GEICO, and the Washington
Post permanent holdings. “Even if these securities were to appear
signi?cantly overpriced, we would not anticipate selling them, just
as we would not sell See’s or the Buffalo Evening News if someone
were to offer us a price far above what we believe those businesses
are worth.
“This attitude may seem old-fashioned in a corporate world in
which activity has become the order of the day. ...”
Buffett may have contradicted himself here. He had also told his
shareholders, “Sometimes, of course, the market may judge a busi-
ness to be more valuable than the underlying facts would indicate it
is. In such a case, we will sell our holdings. Sometimes, also, we will
sell a security that is fairly valued or even undervalued because we
require funds for a still more undervalued investment or one we be-
lieve we understand better.”
Of course, as Buffett explained, Berkshire would not “sell hold-
ings just because they have appreciated or because we have held
them a long time.”
Attempting to deal with this contradiction, Buffett went on to say
that yes, Berkshire would sell overvalued businesses—apart from
Coca-Cola, Gillette, and Capital Cities/ABC.
This inertial attitude derives, no doubt, partly from a desire to re-
assure managers of Berkshire businesses, partly from loyalty, partly
from sentiment, and partly for business reasons. If you sell jim-
dandy Business A and pocket a lot of money, you must ?nd a jim-
dandy Business B that’s for sale. And if the buyer of Business A
overpaid, you yourself might be forced to pay through the nose for
Business B—because prices have gone up everywhere. As Buffett
pointed out, a business that is “both understandable and durably
wonderful” is “simply too hard to replace.”
“Investment managers,” Buffett went on, “are even more hyperki-
netic: Their behavior during trading hours makes whirling dervishes
seem sedated by comparison. ... Despite the enthusiasm for activity
that has swept business and ?nancial America, we will stick with our
’til-death-do-us-part policy. It’s the only one with which Charlie and I
are comfortable, it produces decent results, and it lets our managers
and those of our investees run their businesses free of distractions.”
MORE FROM BUFFETT ON BUYING TO HOLD 111On another occasion: “Our stay-put behavior re?ects our view that
the stock market serves as a relocation center at which money is
moved from the active to the patient.” The idle rich remain rich; the
energetic rich don’t.
In one talk, Buffett condensed three of his investment themes,
buying good companies cheap, not biting off more than they could
chew, and inactivity. Buying “superstars ... offers us our only
chance for real success. Charlie and I are simply not smart enough,
considering the large sums we work with, to get great results by
adroitly buying and selling portions of far-from-great businesses.
Nor do we think many others can achieve long-term investment suc-
cess by ?itting from ?ower to ?ower.”
More of the same advice: “If you aren’t willing to own a stock for
ten years, don’t even think about owning it for ten minutes.” Natu-
rally, a Wall Street expression that Buffett loathes is “You can’t go
broke taking a pro?t.” He’s justi?ed, of course. People do tend to sell
their winners too soon and to hold their losers too long. But some in-
vestors hold their winners so long that they become losers. A com-
promise piece of advice might be: “You can’t go broke taking a few
chips off the table.”
The Gunslinger’s World
Of course, many momentum investors are sophisticated, smart,
and successful. There are famous gunslingers. Among them are
Fred Alger of the Alger Funds, Kenneth Heebner of the CGM
funds, and a variety of Janus managers, several of whom trained
with Alger.
An impressive newcomer among gunslingers is Andrew C.
Stephens of Artisan Mid Cap. The average stock fund manager’s
portfolio had a turnover of 103 percent in the year 2000. The average
large-growth stock manager a turnover of 148 percent. Stephens’
fund had a turnover of 236 percent in 1998, 203 percent in 1999, and
246 percent in 2000. Yet in 1998 his fund beat the S&P 500 by 4.79
percentage points, in 1999 by 36.85 percentage points, and in 2000 by
45.09 percentage points.
If you buy fast-growing, healthy companies rather than companies
that are sleepy if not downright sickly, you must be ready to unload
them at the ?rst sign of serious trouble—their growth is slowing.
Their earnings will probably sink, and their price-earnings ratio will
probably become compressed, because investors no longer have
such rosy views of their future. Growth investors talk about some-
thing called the Greater Cockroach Theory. If you see one, others
112 BE AN INVESTOR, NOT A GUNSLINGERmust be lurking nearby; one earnings disappointment, one piece of
bad news, suggests that others are on the way.
The smaller the fast-growing companies you buy, the more rapidly
they are likely to falter and fade. The people running smaller compa-
nies tend to have less talent on their bench, less money, less experi-
ence; they also risk being put out of business by their bigger,
merciless rivals. That’s why the investor who focuses on small, fast-
growing companies must also be quick on the trigger, ready to sell
what’s been hot and has begun cooling off before others wise up.
When Morningstar checked whether various funds would have
been better off just leaving their portfolios alone for an entire year,
or whether they improved matters by moving in and out, the conclu-
sion was mixed.
Trading large-cap stocks “hardly seems worth it.” In most cases,
managers who puttered with their portfolios added little to their re-
turns. Small-cap portfolios, especially those buying growth stocks,
bene?ted the most from any ?ddling around with their portfolios.
THE GUNSLINGER’S WORLD 113CHAPTER 16
Be Businesslike
While Buffett is clearly an unusually decent gentleman, with rare
exceptions he has remained ?rmly businesslike. He is assigned
the task of making good money for his shareholders, and while he al-
lows room for compassion toward other interested parties, share-
holders come ?rst.
This somewhat stern businesslike attitude has governed not just
Buffett’s investment career, but is re?ected in his personal life. Busi-
ness is business, wherever it is transacted. It was a lesson he may
have learned from his father and from Ben Graham.
As the publisher of one magazine I worked for liked to put it, “We
are not an eleemosynary institution.”
Berkshire Hathaway, the textile mill, was, after all, a company that
Buffett was emotionally attached to. He assured people that he was
opposed to ending the business, laying off its workers, hurting the
economy of New Bedford, Massachusetts. But he did—unhappily.
That was the money manager’s dilemma at its most raw: Are you
more loyal to the investors who own the business or to the employ-
ees of the business? When push came to shove, Buffett, predictably,
sided with the owners.
But not without misgivings and not without straying a bit from his
mandate.
115Here is what he wrote in 1978 in his annual report: (1) Our “textile
businesses are very important employers in their communities; (2)
management has been straightforward in reporting on problems and
energetic in attacking them; (3) labor has been cooperative and un-
derstanding in facing our common problems; and (4) the business
should average modest cash returns relative to investment.” Besides,
“As long as these conditions prevail—and we expect that they will—
we expect to continue to support our textile business despite more
attractive alternative uses of capital.”
In other words, while the business was just okay, Buffett preferred
to continue holding on because of his obligations to the community,
management, and labor—and because his own shareholders would
get a decent cash return, although better investments were available
elsewhere. The money manager as upright human being.
It turned out that Buffett was wrong about Berkshire’s modest
cash returns. Foreign competition was slaughtering the industry in
this country. In 1980 the textile mills began consuming enormous
amounts of cash. “By mid-1985 it became clear, even to me,” Buffett
wrote later, “that this condition was almost sure to continue.” Nor
could he ?nd a buyer.
He went on: “I won’t close down businesses of subnormal prof-
itability merely to add a fraction of a point to our corporate rate of
return. However, I also feel it inappropriate for even an exception-
ally pro?table company to fund an operation once it appears to have
unending losses in prospect.” Adam Smith wouldn’t approve of his
not closing down a not-very-pro?table business, he went on, and
Karl Marx wouldn’t have approved of his not supporting a dying in-
dustry. But “the middle ground is the only position that leaves me
comfortable.”
Many other U.S. textile-mill owners had shut their plants sooner:
They had the same information he himself had, but “they simply
processed it more objectively.” He had ignored the advice of the
philosopher Auguste Comte: the “intellect should be the servant of
the heart, but not its slave.”
Buffett has declared that “Good pro?ts are not inconsistent with
good behavior.” But when they are, pro?ts must come ?rst.
Other instances of Buffett’s adherence to a semitough busi-
nesslike philosophy:
•After Buffett invested in the Buffalo News and experienced all
sorts of trouble, the paper’s chief competitor, the Courier-Express,
suddenly folded. At a meeting of managers soon after, someone
asked about pro?t sharing for employees in the newsroom.
116 BE BUSINESSLIKERoger Lowenstein, Buffett’s biographer, comments that “On its
face, this seemed reasonable.” The employees had done what was
expected of them.
Replied Buffett, “There’s nothing that anyone on the third ?oor
[editorial] can do that affects pro?ts.” A dubious notion. The more
skilled newspaperpeople could go elsewhere, lowering the quality of
the paper. But, after all, in Buffett’s mind shareholders come ?rst.
Lowenstein wrote that Buffett “was merely living up to his brutal-
but-principled capitalist credo.”
•Early in his career, Buffett began buying Dempster Mill Manu-
facturing, a farm equipment manufacturer in Beatrice, Nebraska.
In 1961 he bought a controlling interest and became chairman. He
wasn’t a huge success at persuading the management to cut the in-
ventory and shrink the costs. Then he hired someone, Harry Bot-
tle, to come in and take over Dempster. Bottle cut costs
drastically. Some 100 people were let go, and in Beatrice, Buffett
was roundly criticized.
A friend teasingly asked Buffett, “How can you sleep at night after
?ring all those people?”
Said Buffett, for whom this was a sensitive subject, “If we had
kept them, the company would have gone bankrupt. I’ve kept close
tabs and most of them are better off.”
•When Buffett became chairman of Salomon during its troubles
in the early 1990s (a trader had tried to trick the Treasury into giv-
ing him more than his allotment of securities), he was outraged at
the bonuses the executives were raking in. They wound up with al-
most 75 percent of the company’s pro?ts, which explains why
shareholders were so unhappy. Among companies in the S&P 500,
the return on Salomon’s stock was 445th. A wonderful company but
a lousy stock, Buffett called it. Then, in an advertisement in the Wall
Street Journal and other giant newspapers, Buffett denounced Sa-
lomon’s pay scale and announced that he was taking $110 million
away from the bonus pool for 1991, even though pro?ts had climbed
(before the scandal). Salomon laid off 80 executives and 200 sup-
port staff. Managers’ bonuses were cut 70 percent. Eventually the
company turned around.
•Buffett put in a bid to bail out Long Term Capital Management,
the hedge fund, when it was in the midst of its death throes. The U.S.
government ?nally rode to the rescue with a loan, fearing the reper-
cussions in the ?nancial markets if the company went belly-up. But
before then, Buffett had put in a bid for all of Long Term Capital
Management’s assets, a bid so lowball that everyone was shocked.
But it was vintage Buffett.
BE BUSINESSLIKE 117An Exception
Still, on at least one occasion in his career Buffett (and Munger) let
sentiment sneak into their cold business world.
Both Buffett and Munger were big owners of Blue Chip Stamps,
and both decided to buy shares of Wesco Financial of Pasadena,
California, which owned a savings and loan. Then Wesco an-
nounced that it would merge with another California savings and
loan, Financial Corporation of Santa Barbara. Buffett and Munger
tried to stop the merger, whose terms they felt were decidedly un-
fair to Wesco. Munger visited Louis R. Vincenti, Wesco’s president;
Buffett visited Elizabeth Peters, Wesco’s largest shareholder. Buf-
fett succeeded in persuading her to vote with him against any
merger.
When the merger was called off, the stock began falling. Buffett
and Munger could have loaded up on cheap shares then, but instead
they decided to pay the higher price that had prevailed before the
merger fell through—something they had been responsible for. Said
Munger, who like Buffett was a straight arrow: “We decided in some
quixotic moment that it is the right way to behave.”
118 BE BUSINESSLIKE
In Business and Family
In intrafamily relations Buffett has also been Scrooge-like, insisting that his
family members be self-reliant. Once his sister, Doris, to make quick money,
had taken the reckless step of selling options on stocks she didn’t own, and
wound up $1.4 million in debt. Buffett reorganized a family trust so she would
get monthly income, but he refused to pay off the debt. Doris had to default.
When daughter Susie got married and became pregnant, she wanted to
expand the tiny kitchen in her townhouse in Washington, D.C. Cost: about
$30,000. She asked her father for a loan, at current interest rates. He said no.
“Why not go to the bank and take out a loan like everyone else?” Why should
he show favoritism to his daughter? (The answer should have been obvious.)
Son Howie wanted to be a farmer. Buffett, in an unusually magnanimous
gesture, offered to buy a farm (with a rather low maximum limit) and rent it to
his son on standard terms. Howie ?nally found a farm that cheap—after
knocking himself out seeing a hundred of them.
“[W]hen even close friends asked him for money, and for worthy causes,”
writes Lowenstein, “Buffett sent them packing.”The Securities and Exchange Commission (SEC) thought some-
thing was rotten about the whole deal.
In questioning Munger later on, an SEC lawyer asked: “Why
would you intentionally pay a higher price for something you
could get for less?” Said Munger, “We wanted to look very fair and
equitable to Lou Vincenti and Betty Peters.” Lawyer: “What about
your shareholders? Didn’t you want to be fair to them?” Munger:
“Well, we didn’t feel our obligation to shareholders required us to
do anything which wasn’t consistent with leaning over backwards
to be fair.”
When Buffett was asked about his responsibility to Blue Chip
shareholders, he replied that “I own a fair amount of the stock.” The
lawyer asked whether it would have looked bad if he had bought
Wesco stock cheaply right after the merger fell through. “I think
someone might have been sore about it,” he replied. Buffett also tes-
ti?ed that he wanted to remain on good terms with Vincenti, Wesco’s
president. “If he felt that we were, you know, slobs or something, it
just wouldn’t work.”
In 1976 after a two-year investigation, the SEC charged that Blue
Chip had propped up the price of Wesco by insisting on buying
shares at a higher than market price. Blue Chip was ordered to pay
$115,000 to various Blue Chip shareholders who, the SEC decided,
had been hurt because Buffett and Munger had been buying shares
arti?cially high.
It was just a slap on the wrist, but it’s what happens when busi-
nessmen try to act like gentlemen.
In short, investors out to emulate Buffett’s investment style should
be steadfastly businesslike. Ethical investing may have its place, but
what you are seeking, ?rst and foremost, is pro?tability.
Just because an investor favors a particular company’s pro-female
or pro-minority policies, or because he or she once worked there
and the company was benevolent, are not suf?cient reasons to con-
tinue investing in it—unless it’s a good investment in its own right.
Even the fact that a company’s stock has blessed you with enormous
returns in the past is no reason for you to remain loyal if the com-
pany is fast going down the drain.
The old Wall Street warning, A stock doesn’t know that you own it,
wouldn’t be repeated so often if people didn’t bring so much emo-
tional baggage to their investment portfolios.
If you want to show everyone how smart you are, join Mensa.
Don’t try to prove it in the stock market. And if you want to give vent
AN EXCEPTION 119to your compassion and loving-kindness, send checks to charitable
institutions directly. Don’t try to express your humanity by increas-
ing the likelihood that you will make bad investments.
Avoiding bad investments, though, does not mean that you must
glom onto seemingly good investments that might offend your sense
of ethics, like tobacco or armaments companies. You can, as Buffett
does, wait for other good pitches. Just don’t swing at bad pitches—
even if the pitcher is your sister, daughter, or son.
120 BE BUSINESSLIKECHAPTER 17
Admit Your Mistakes
and Learn from Them
Agonizing over errors is a mistake. But acknowledging and analyzing them can be
useful, though the practice is rare in corporate boardrooms. There, Charlie and I have
almost never witnessed a candid post-mortem of a failed decision, particularly one
involving an acquisition. ... The ?nancial consequences of these boners are regularly
dumped into massive restructuring charges or write-offs that are casually waved off as
“nonrecurring.” Managements just love these. Indeed, in recent years it has seemed
that no earnings statement is complete without them. The origins of these charges,
though, are never explored. When it comes to corporate blunders, CEOs invoke the
concept of the Virgin Birth.
—Warren Buffett
O
ne recurring theme of the Berkshire annual reports is: Buffett
makes a lot of mistakes. As he wrote in the 2000 annual report,
“I’m the fellow, remember, who thought he understood the future
economics of trading stamps, textiles, shoes, and second-tier depart-
ment stores,” referring to seeming blunders he had made in the past.
In the reports, the litany of mistakes tends to come right up
front. The 1999 report discusses “just how poor our 1999 record
was.... Even Inspector Clouseau could ?nd last year’s guilty
party: your Chairman.” He describes the mistakes; he tries to ?g-
ure out why he made them; and he assesses the consequences of
those mistakes.
Admitting mistakes and trying to learn from them seems to be
an attribute of gifted investors—and of gifted people in general.
Let’s look at how Buffett has discussed some of his mistakes in the
past:
•In the 2000 annual report he confesses, “I told you last year
that we would get our money’s worth from stepped up advertising
at GEICO in 2000, but I was wrong. ... The extra money we spent
did not produce a commensurate increase in inquiries. Additionally,
121the percentage of inquiries that we converted into sales fell for the
?rst time in many years. These negative developments combined to
produce a sharp increase in our per-policy acquisition cost.” (He
gives more details about the problem, pointing out that a key com-
petitor, State Farm, has resisted raising its prices.)
•Why didn’t he repurchase shares of Berkshire Hathaway when
they were cheap?
“You should be aware,” he has said, “that, at certain times in the
past, I have erred in not making repurchases. My appraisal of Berk-
shire’s value was then too conservative or I was too enthused about
some alternative use of funds. We have therefore missed some op-
portunities. ...” Granted, he continued, he did not miss out on mak-
ing a great deal of money.
•“I clearly made a mistake in paying what I did for Dexter [a shoe
company] in 1993. Furthermore, I compounded that mistake in a
huge way by using Berkshire shares in payment. ...”
•(Talking about Berkshire Hathaway textiles): “We also made a
major acquisition, Waumbec Mills, with the expectation of important
synergy. ... But in the end nothing worked and I should be faulted
for not quitting sooner.”
•“Shortly after purchasing Berkshire, I acquired a Baltimore de-
partment store, Hochschild, Kohn, buying through a company called
Diversi?ed Retailing that later merged with Berkshire. I bought at a
substantial discount from book value, the people were ?rst class,
and the deal included some extras—unrecorded real estate values
and a signi?cant LIFO cushion [potential tax deduction]. How could
I miss? So-o-o—three years later I was lucky to sell the business for
about what I paid. ...”
•“Late in 1993 I sold 10 million shares of Cap Cities at $63; at
year-end 1994, the price was $851
/4. (The difference is $222.5 million
for those of you who wish to avoid the pain of calculating the dam-
age yourself.)”
“Egregious as it is, the Cap Cities decision earns only a silver
medal. Top honors go to a mistake I made ?ve years ago that fully
ripened in 1994: Our $358 million purchase of USAir preferred
stock, on which the dividend was suspended in September....
This was a case of sloppy analysis, a lapse that may have been
caused by the fact that we were buying a senior security [owners
of preferred stock must be paid dividends before owners of com-
mon stock] or by hubris. Whatever the reason, the mistake was
large.”
122 ADMIT YOUR MISTAKES AND LEARN FROM THEM•Another mistake: Buying Gillette preferred instead of Gillette
common. “But I was far too clever to do that. ... If I had negotiated
for common rather than preferred, we would have been better off at
year end 1995 by $625 million, minus the ‘excess’ dividends of about
$70 million.”
Learning from Mistakes
Not learning from your mistakes, of course, may mean that you may
repeat those mistakes or make similar mistakes.
Learning means: recognizing that it was a mistake, despite any ex-
cuses that you might have been tempted to make, and pledging to
recognize such a situation in the future and to avoid making the
same or a similar mistake.
One of the worst investors of our time was the late Charles
Steadman, whose Steadman funds year after year lost money.
Steadman Oceanographic lost around 10 percent of its value every
year for 10 years. Such consistency, even among poor-performing
mutual funds, is rare. What Steadman, a lawyer who was not unin-
telligent, did wrong was: (1) buy story stocks, those that had excit-
ing tales to tell, such as a company that claimed to breed
disease-free pigs; (2) buy stocks with no persuasive numbers be-
hind them; and (3) make the same mistake again and again. He
must have had a powerful need to impress people by reaping extra-
ordinary pro?ts from colorful companies. Or he was simply unable
to resist the allure of story stocks. Perhaps he had once made a
killing on a story stock, and yearned to feel once again the ecstasy
of that experience, the giddy sensation of far greater wealth, of
soaring self-con?dence and self-satisfaction.
People who can confront and analyze their mistakes seem to have
deep-seated self-con?dence. They know that, despite their lapses,
they are still worthwhile, talented individuals—and perhaps even
gifted in whatever line of activity they made their mistakes. (Or they
have just trained themselves, or been trained, to endure the pain of
self-criticism, recognizing the bene?ts.)
Charles Bosk, a sociologist at the University of Pennsylvania, has
conducted a series of interviews with young physicians who had left
neurosurgery-training programs. Either they had been let go, or they
had resigned. What, he wondered, separated these young doctors
who went on to become surgeons from those who had faltered and
stumbled along the way?
LEARNING FROM MISTAKES 123It wasn’t so much a resident’s intelligence or dexterity, Bosk de-
cided, as much as the person’s ability to confront the possibility, the
causes, and the consequences of his or her mistakes, and to take
steps to keep them from recurring. Quoted in The New Yorker maga-
zine (Aug. 2, 1997), Bosk said:
When I interviewed the surgeons who were ?red, I used to leave the inter-
view shaking. I would hear these horrible stories about what they did
wrong, but the thing was that they didn’t know that what they did was
wrong.
In my interviewing, I began to develop what I thought was an indicator
of whether someone was going to be a good surgeon or not. It was a cou-
ple of simple questions. Have you ever made a mistake? And, if so, what
was your worst mistake?
The people who said, ‘Gee, I really haven’t had one,’ or ‘I’ve had a cou-
ple of bad outcomes, but they were due to things outside my control’—in-
variably those were the worst candidates.
And the residents who said, ‘I make mistakes all the time. There was
this horrible thing that happened just yesterday and here’s what it was.’
They were the best. They had the ability to rethink everything they’d done
and imagine how they might have done it differently.
Possibly these surgeons had not made mistakes, in the sense that
they had done something that they should not have done—or not
done something they should have. Just as you can buy a stock that
goes down without your making a mistake—you couldn’t have
known about, say, a new lawsuit—a surgeon can have a bad out-
come that is not his or her fault. Perhaps the patient had health con-
ditions the surgeon and hospital weren’t aware of. But assiduously
checking into the causes of mishaps in general—stocks of yours that
plummet, patients who have bad results—even if the mishaps aren’t
your mistakes, can be as bene?cial as trying not to repeat mistakes
that result from a failure on your part.
Peter Lynch has admitted that he would sometimes buy a stock at
$40, sell it at $50, then buy it again at $60. He didn’t fear the pain of
humiliation, of experiencing a decline in his self-esteem, by his pub-
licly acknowledging that he had done something he should not
have—sold that stock at $40. (If I had seen that the stock rose
briskly after I sold it, I would out of shame never have looked at its
price again.) By the same token, Gentleman Jim Corbett, the heavy-
weight champion boxer, was said to have been very polite to other
men. No one would suspect him of being afraid of them. No one
124 ADMIT YOUR MISTAKES AND LEARN FROM THEMwould think Peter Lynch was not a gifted investor, despite occa-
sional lapses. And, of course, no one thinks less of Warren Buffett
for his compulsively studying his so-called mistakes.
He plays bridge the same way. “When he makes a stupid mis-
take,” Carol Loomis has written, “he tends to be hard on himself. ‘I
can’t believe that I did that,’ he said recently after one hand. ‘That
was incredible.’”
LEARNING FROM MISTAKES 125CHAPTER 18
Avoid Common
Mistakes
O
nce, when Warren Buffett was asked to explain his success as an
investor, he gave a simple answer: “I’m rational.” He generally
doesn’t make the emotional, silly, and illogical mistakes most in-
vestors are prone to making.
Not long ago, I sold $20,000 shares of SBC and bought two $10,000
positions in Berkshire Hathaway and P?zer. I still had $20,000 left in
SBC. But when I look at my stocks now, I’m delighted that Berkshire
and P?zer have risen—and even pleased that SBC has fallen—be-
cause all of these steps con?rm how clever I am. I have to remind
myself that I’m still behind because I have lost more money in SBC
than I have gained in Berkshire and P?zer.
Psychologists have devised a term for behavior like mine, where
I try to fool myself into thinking what I did was very clever: “stu-
pidity.” Another term they use is “recency”: People tend to
overemphasize things that have happened recently. If there’s a
?ood nearby, people will buy more homeowners’ insurance; if a
stock has been going up and up, people are likely to jump on the
bandwagon.
Like all other psychological mistakes, recency can serve a useful
127purpose. Maybe ?oods are getting more common these days;
maybe that stock will continue going up because (1) some profes-
sional investors are gradually buying big positions and (2) new in-
vestors keep discovering it. But focusing on recent purchases, and
overlooking the stocks that have been in a portfolio for years, can
be a costly mistake.
Related to recency is “extrapolation,” the human tendency to
think that whatever has been happening will continue to happen; the
number that comes after 1, 3, 5, and 7 is 9. Extrapolation is a useful
guide in life. A good restaurant deserves a return visit; a friend who
gives useful advice is worth consulting again. But it doesn’t always
work in the stock market, where a stock or the market itself can be-
come excessively expensive, where the number that comes after 1,
3, 5, and 7 may be minus 12.
A recent and striking event can have a far greater impact on our
psyches. A recent airplane crash may lead us to buy more airplane
insurance; a recent decline in the stock market can cause us to panic
and sell.
Obviously, we investors are a neurotic lot. Just consider how
many investors think that they don’t really have a loss unless
they sell a losing stock; and how many other investors believe
that an individual bond is better than a bond fund because you
can’t lose money on an individual bond if you don’t sell it before
maturity (assuming that it doesn’t default). It’s the same fallacy:
An individual bond that’s worth less is a loser even if you don’t
sell it.
Yet, ironically, a popular theory for many years has been the ef?-
cient market hypothesis, the notion that stock prices are reason-
able because all information is distributed quickly and equally,
and all investors are intelligent and logical. The evidence seems to
?t better with the Nutty Investor Theory, the notion that stock
prices are frequently too high or too low because a great many in-
vestors are illogical.
To do well in the stock market, as Buffett has, it helps enormously
just to resist the common psychological mistakes that other in-
vestors make.
Perhaps the single most important mistake is recency/saliency/ex-
trapolation, which drives markets up too high and drives them down
too low. “The major thesis of this book,” writes a noted value in-
vestor, David Dreman, in Contrarian Investment Strategies: The
Next Generation (New York: Simon & Shuster, 1998), “is that in-
128 AVOID COMMON MISTAKESvestors overreact to events. Overreaction occurs in most areas
of our behavior, from the booing and catcalling of hometown fans
if the Chicago Bulls or any other good team loses a few consecu-
tive games, to the loss of China and the subsequent outbreak of
McCarthyism. But nowhere can it be demonstrated as clearly as in
the marketplace.”
Other common psychological mistakes include:
LOSS AVERSION. People seem to hate losses twice as much as they
love winners. They will accept a bet where the odds may be 2 to 1 in
their favor, but no less. Many experiments have con?rmed this. I my-
self presented this case to a group of investors: In your company
cafeteria you overhear the president and chairman talking about
how wonderful things are. Earnings are going up; a new product is
?ying off the shelves; a big competitor is in big trouble. Do you buy
more shares? About half would, half wouldn’t. Again, you’re in your
company cafeteria. You already own the stock. You overhear the
president and chairman lamenting how lousy things are. Earnings
are down; a new product has bombed; a big company is beating you
up big-time. Do you sell? Everyone would sell.
I once asked Richard Thaler, a leader in behavioral economics, to
explain the origin of loss aversion: It’s an inheritance from our prim-
itive days, he said, when losses—of food, shelter, safety—imperiled
your very life.
LOVE OF GAINS. Investors are also prone to selling too quickly; instead
of selling their losers and letting their winners ride, they hold onto
their losers and sell their winners. Perhaps they are afraid that their
gains will vanish if they wait too long. A bird in the hand ...
THE PATHETIC FALLACY. A term coined by art critic John Ruskin, it en-
tails endowing inanimate objects with human qualities. For instance:
not selling a stock because when you were an employee the com-
pany treated you generously, or because a favorite relative be-
queathed it to you, or because the stock once blessed you with
princely returns and you don’t want to be an ingrate by selling it. A
stock, as the saying goes, doesn’t know that you own it. (Also called
“personalization.”)
SEPARATING MONEY INTO DIFFERENT CATEGORIES. This can occur when, for
example, you’ve doubled your money on American Antimacassar,
AVOID COMMON MISTAKES 129and that prompts you to invest your pro?ts more aggressively
because it was easy money rather than money you worked hard
for.
COGNITIVE DISSONANCE. It can be painful to change your mind, to sub-
stitute one set of beliefs for another. That may be why analysts tend
to be slow in upgrading a stock that has a positive earnings surprise,
and to be slow in downgrading a stock with a negative earnings sur-
prise. Related to this is the “endowment effect”: People tend to ac-
cept evidence that supports whatever they already believe (a stock
that they own is a good buy) and reject evidence that con?icts with
what they believe (a stock they own is a dog).
AVOIDANCE OF PAINFUL MEMORIES. I would never consider buying Intel
because the very name reminds me that I foolishly sold the stock 20
years ago. I have trouble buying any stock or mutual fund that cost
me money in the past.
CONTAMINATION. Some stocks get hurt because others in the same in-
dustry have been hurt. But a company in one industry could prove
immune from the epidemic, and even bene?t later on if its competi-
tors lose their shares of the business. Shrewd investors like to zero
in on companies in a suffering industry that seem to be immune, the
way Buffett bought Wells Fargo during a period of bank troubles and
has been glomming onto companies with asbestos problems re-
cently. (Sometimes called “false parallels.”) By the same token, some
stocks take off because they’re in a favored industry, such as Inter-
net stocks, even though they may be exceptions. This is called the
Halo Effect.
COMPLEXITY. In some situations, even sophisticated investors aren’t
sure what to do. There are lots of good reasons to buy, lots of good
reasons not to buy. One money manager, Brian Posner, told me that
that’s what he looks for—complicated situations, where by intense
study he can gain an edge over other investors.
TOP-OF-THE-HEAD THINKING. I once got a solid tip from a friend in the
medical arena that P?zer, the pharmaceutical company, was in a
lot of trouble. It had manufactured a heart valve that was defec-
tive, and everyone with such a valve might sue. I sold my 100
shares of the stock at $79 and smugly watched as the news got out
130 AVOID COMMON MISTAKESand the price starting dropping—$78, $76, $74, $72. Then, over the
course of the next year, P?zer went to $144. You’ve heard that hap-
piness is a stock that doubles in a year? I have a neat de?nition of
the word “misery.”
A year after I sold my P?zer, I asked Ed Owens, portfolio manager
of Vanguard Health Care Portfolio, to tell me about something he
was proud of having done recently. He mentioned buying all the
shares of P?zer that he could lay his hands on. Didn’t he know about
the defective heart valve? Yes, of course, but he and his analysts ?g-
ured that if everyone with a defective heart valve sued, it would
knock just one point off P?zer’s price. Meanwhile, the company had
all sorts of promising drugs in its pipeline, including one with a
funny name: Viagra.
THINKING INSIDE THE BOX. So many investors, having lost money on In-
ternet stocks, for example, feel that they must regain their money by
holding onto their Internet stocks. But, as Buffett has said, you don’t
have to make it back the same way you lost it.
ANCHORING. People seem hungry for any sort of guidance. Tell them
the date when Attila the Hun invaded Europe, and they will use that
off-the-wall number to guide them in estimating the population of
Seattle or Timbuktu. In the stock market, people will anchor on a
stock’s yearly high, or the price at which they bought it. If the high
was $50, they will think it must be cheap at $25 (especially if they
are adherents of the ef?cient market hypothesis). If they bought it
at $50, then it declined, they may wait until it reaches $50, then un-
load it.
THE HERD INSTINCT. Many people will go with the ?ow—even good in-
vestors, one of whom once told me that he will buy only on an
uptick. Often the voice of the people is indeed the voice of God; if I
was in a theater and everyone began running madly for the exits, I
would try to beat them out the door. Often, though, especially in the
stock market, the voice of the people is plain wrong. Of course, peo-
ple also have a tendency to be stubborn, to ignore the crowd. There’s
a ?ne line between courage and stubbornness.
OVERCONFIDENCE. Lawyers, drivers, physicians all think that they are
better than they are—in winning cases, in avoiding accidents, in di-
agnosing illnesses. Positive thinking can be bene?cial. You apply for
AVOID COMMON MISTAKES 131jobs for which you don’t have the requisite experience; you enthusi-
astically undertake projects where you may be over your head. But
overcon?dence can also lead investors in particular to take too
much risk, to overestimate their knowledge and skill, to trade too
much, to stubbornly refuse to sell.
THE SUNK COST FALLACY. People will send good money after bad. If
you’ve spent $500 getting an auto repaired, it’s very painful to
junk the car and buy a new one but somewhat less painful to put
more money into the car. By the same token, some people are
tempted to buy more shares of a stock that has gone down—
perhaps also to prove to themselves that they weren’t dopes for
buying it high.
OVERLOOKING SMALL EXPENSES, ESPECIALLY IF THEY ARE REPEATED. Small
leaks, as Munger likes to say, sink great battleships. Gary Belsky
and Thomas Gilovich, in their book Why Smart People Make Big
Mistakes—And How to Correct Them (New York: Simon & Schus-
ter, 1999), call this “Bigness Bias.” Or, as Harold J. Laski, the polit-
ical analyst, once pithily observed, Americans tend to confuse
bigness with grandeur.
THE STATUS QUO BIAS. People apparently would rather do nothing
rather than do something that would be a mistake. They are hap-
pier holding onto a stock that loses half its value than they are
selling stock one and buying stock two, which also loses half its
value. This is reinforced by folk wisdom: out of the frying pan into
the ?re.
CONFUSING THE CASE RATE WITH THE BASE RATE. If you look at one case,
the answer may seem to be X; but if you look at many cases simi-
lar to that case, you may see that the usual answer is Y. A well-
known example: In college, Jane was interested in books. Is she
more likely to be a librarian now or a salesperson? Answer: Sales-
person, because there are far more salespeople in the United
States than librarians. In the stock market, investors may think
that a particular Internet stock is bound to succeed, paying scant
attention to how many other similar Internet stocks have fallen by
the wayside.
NOT DISTINGUISHING BETWEEN WHAT’S IMPORTANT AND WHAT’S TRIVIAL. Psy-
chological tests indicate that when investors are given far more in-
132 AVOID COMMON MISTAKESformation, they become more con?dent—but not better investors.
Perhaps only the very best investors can distinguish the wheat from
the chaff. During World War II, the U.S. Army Intelligence broke the
Japanese war code and began deluging General George C. Marshall
with decoded messages. He ?nally exploded in frustration: Stop
sending me so many trivial messages.
AVOID COMMON MISTAKES 133CHAPTER 19
Don’t Overdiversify
A
s an investor Buffett prefers to have a concentrated portfolio, one
with relatively few securities in comparison to the amount of
money invested.
A concentrated or “focused” portfolio has a number of clear-cut
advantages:
•You can become familiar with 25 companies far better than
50; you can also track their activities more easily. (More than
one portfolio manager has said that 70 is the most stocks he
or she can follow.)
•You can zero in on your very favorite stocks—not your second
favorites.
In short, you can choose better stocks for a concentrated port-
folio and, because you have more time and energy to study this
more limited portfolio, you can follow your investments more
intensively.
Of course, it is possible to make a case against a concentrated
portfolio:
•A mistake could be more costly. If you own 100 stocks with
each representing 1 percent of your portfolio, a 50 percent
135decline in one stock would lower your portfolio by only 0.5
percent. If you owned 50 stocks, the decline would be 1.0
percent.
•It can be hard to distinguish between your favorite and your
second-favorite choices. Several fund managers have told me
that they cannot tell in advance which of the stocks in their
portfolios will do exceptionally well and which might crater.
•A large position in a stock, or a medium-sized position in a
thinly traded stock, can be hard to unwind without driving the
price down.
•An incontrovertible bene?t of an index fund is its wide diversi?-
cation across different stocks in different industries. Not many
actively managed funds actually do better than large-company
index funds (although this may be largely because index funds
are so cheap to run).
The sensible conclusion is that, for most investors, a concentrated
portfolio is a perilous undertaking, and they might be better advised
to build a well-diversi?ed portfolio.
A concentrated portfolio, on the other hand, could be suitable for
an unusually capable investor; the skill of that investor may offset
any added risk brought about by the narrowness of the portfolio.
The fastest horses can carry the heaviest weights.
For the average investor, having a concentrated portfolio—say, of
six or seven stocks—could spell disaster. The ordinary investor
should diversify across a variety of different stocks and different in-
dustries. In this case, at least, the ordinary investor should blithely
ignore Buffett’s recommendation.
Buffett has apparently recognized that his recommendation that
people own only six or seven stocks might be ill advised. In one talk,
he actually advocated that investors consider index funds.
A Look at Performance
A study of concentrated mutual fund portfolios that Morningstar
conducted (October 2000) found, not surprisingly, that they were
more likely to have extremely good, or extremely bad, records.
Some focused funds, like Janus Twenty, have enjoyed spectacu-
larly ?ne results. (The fund, despite its name, might own 50 stocks.)
Clipper, a concentrated fund run by James Gipson, has also excelled.
(See Chapter 29.) But Yacktman Focused, run by a well-respected
value investor, Donald Yacktman, has suffered horribly during most
of its life.
136 DON’T OVERDIVERSIFYMorningstar editors have conducted two enlightening studies of
concentrated portfolios. In the ?rst, they examined funds with 30 or
fewer holdings over a three-year period. The funds were limited to
those investing mostly in U.S. securities, but they could be sector
funds, specializing in, say, health care. There were 75 such funds.
Compared with very similar funds (large-company value versus
large-company value, for example), the concentrated funds tended
to be top performers—or bottom performers. Not average.
The winners, like Strong Growth 20 and Berkshire Focus, might
have invested heavily in technology stocks. Or, like Clipper, Oak-
mark Select, and Sequoia, they might have mostly avoided technol-
ogy. But there was apparently a tendency for the winners to have
made big bets. Amerindo Technology had more than 40 percent of its
assets in one stock, Yahoo, in 1998. Oakmark Select’s choosing cable
stocks helped account for its good fortune.
Still, it is important to remember that only a three-year period was
chosen. Big bets might not pay off as well over longer time periods.
“Essentially,” Morningstar concluded, “the differences in perfor-
mance boil down to stock-picking.” In other words, money man-
agers with ?ne records tended to continue doing well with focused
portfolios.
Most of the concentrated funds, Morningstar also found, were
more volatile than other funds. Marsico Focus soared 34 percent in
late 1999; it fell more than 18 percent between March and May of
2000. During these periods, Marsico Focus diverged from other
large-growth funds by around 10 percentage points. PBHG Large
Cap 20 rose 75 percent in the last quarter of 1999, then dropped
more than 20 percent between March and May of the following year.
Surprisingly, even concentrated value funds were unusually
volatile. Sequoia fell 16 percent between December 1999 and Febru-
ary 2000, then gained 21 percent between March and May 2000. Dur-
ing these periods, its performance diverged from the performances
of other large-value funds by 10 percentage points. (I suspect that re-
cent years have been unusual for value funds, and that concentrated
value portfolios would tend, like value funds in general, to be less
volatile than concentrated growth funds.)
In its second study, Morningstar looked at quasi-concentrated
funds: those that had at least 50 percent of their assets in their 10
largest holdings. They found that it wasn’t a bad idea at all for some-
what diversi?ed funds to concentrate their assets in their top hold-
ings. In other words, for a fund to compromise: to have a lot of
different stocks, but to tilt toward its favorites. (Exception: sector
funds. Those that overweighted their top 10 holdings tended to do
DON’T OVERDIVERSIFY 137miserably. Morningstar’s puzzling explanation: “ ... most likely be-
cause most stocks in a sector often move together.” Perhaps it’s just
harder to bet on differences between similar stocks.)
Another ?nding from this second experiment: It paid to buy and
hold. Top-performing funds like Janus Twenty “hold onto winners
longer than their competitors do, so individual positions are allowed
to mushroom in size as they perform better. Thus, their contribution
to a fund’s performance is more meaningful.”
The better-performing funds among the quasi-concentrated funds
also tended to be a little more volatile than their peers, which isn’t
surprising.
The overall conclusion that one can draw from Morningstar’s stud-
ies is just what one might expect: Concentrated portfolios can be
perilous. Concentration, states Morningstar, “produces extreme per-
formance, but it isn’t actually better on average.”
In Sum
No doubt, the better the investor you are, the less you need to diver-
sify. Unfortunately, the cruel fact is that there is a law for the lion
and a law for the lamb; a law for geniuses like you-know-who and a
law for Joe Schmos like you and me.
Buffett can get away with having a concentrated portfolio. In fact,
it helps account for his glittering record. He knows his companies
backward and forward. While you and I have been wasting our lives
watching football games and reading John Grisham novels, he’s been
reading balance sheets. You know what he does for fun? Reads quar-
terly reports.
I recall hearing Phil Rizzuto, the light-hitting former Yankee
shortstop, talking on television. Someone mentioned to him that
Ralph Kiner’s advice to other hitters was: Always swing as hard
as you can. (Ralph Kiner hit a lot of home runs.) Replied Phil
Rizzuto, in shock: “Holy cow, that’s about the worst advice I’ve
heard in my whole life!” It was advice suitable for Mr. Kiner, not
for Mr. Rizzuto.
You and I and Phil Rizzuto—let’s face it—should be very content
with singles. Ralph Kiner and Warren Buffett, on the other hand,
have been among the very small percentage of humanity quali?ed to
swing for the fences.
Buffett, who is, after all, very smart, has acknowledged as much.
He has said that he sees nothing wrong with investors putting money
into index funds. He was referring to “an investor who does not un-
derstand the economics of speci?c businesses [but who] neverthe-
138 DON’T OVERDIVERSIFYless believes it in his interest to be a long-term owner of American
industry. That investor should both own a large number of equities
and space out his purchases [practice dollar-cost averaging]. By peri-
odically investing in an index fund, for example, the know-nothing
investor can actually outperform most investment professionals.
Paradoxically, when ‘dumb’ money acknowledges its limitations, it
ceases to be dumb.”
IN SUM 139CHAPTER 20
Quick Ways to
Find Stocks That
Buffett Might Buy
Warren Buffett buys stocks that he considers to be sure things. He
has an aversion to gambling, and wants the odds to be ?ve or ten or
even 100 to one in his favor—which is not normally considered gam-
bling. That’s one reason why an investor should be wary of putting
money into stocks that seem to meet a few of Buffett’s investment cri-
teria. Buffett himself would tend to reject any stocks with even a faint
whiff of doubt, emulating his mentor, Ben Graham. And he would try to
research the heck out of any company, like the fanatics he admires.
He also uses qualitative, non-mathematical criteria to judge com-
panies—in particular, the quality of management. The ordinary in-
vestor, unfortunately, has limited access to top business people. If
Warren Buffett phoned the XYZ Corporation and asked to speak to
the CEO, he would not be referred to “shareholder relations,” the
way you and I would. And talking to management and evaluating
management can provide strong evidence, or even just subtle clues,
as to whether to buy a stock.
In short, buying stocks that, from the numbers alone, might inter-
est Buffett is not as safe a strategy as an investor might believe. Find-
ing stocks that seem to ?t Buffett’s criteria is useful for anyone
seeking to emulate Buffett, but that should be only a starting point.
Buffett expert Robert Hagstrom suggests that you then obtain annual
141reports and 10(k)s, study what analysts have to say, read interviews
with management, and so forth. And, I would add, the less extra re-
search you do, the more such Buffett-type stocks you might buy.
The lesser investor had better think not only of diversifying, but of
leaving a ship that begins to take on a lot of water—and certainly not
holding on forever.
A ?nal warning: Edwin Walczak, who runs a mutual fund that fol-
lows Buffett’s approach, Vontobel U.S. Value (see Chapter 28), re-
ports that if you get ?ve Buffett imitators in conversation, each will
hold a basket of stocks that the others don’t.
Robert Hagstrom
With these warnings, the reader should know that there is a web site
that lists Buffett-type stocks, chosen by criteria set up by none other
than Robert Hagstrom. (See Chapter 20.)
To reach the web site, go to Quicken.com
Hagstrom is quick to warn visitors that the stocks listed—which
have been chosen by Quicken, using Hagstrom’s formula, and not by
Hagstrom himself—aren’t a royal road to riches.
He writes: “... even if you use the tenets outlined in One-Click
Scorecard and you do the follow-up research necessary before buy-
ing a stock, it is not likely that you will generate [a] 23 percent aver-
age annual gain over the next 30 years. Even Mr. Buffett admits that
the possibility of his repeating this long-term performance is remote.”
Still, Hagstrom adds that “I do believe that if you follow these
tenets you will stand a better chance of outperforming the market.”
The web site lists well over 100 stocks that have passed at least six
of the criteria recommended by Hagstrom. Your “next step should be
an evaluation of a company’s management,” he advises. “This is just
a starting point.” As Hagstrom sees it, Buffett studies four essentials
about a company: (1) the company itself, (2) the management, (3)
the ?nancials, and (4) the asking price—in that order.
The site also provides the visitor with information about the vari-
ous companies and a company pro?le.
In February 2001, these were the ?rst 20 stocks listed on the web
site, their order determined by how high their apparent “discount to
intrinsic value” was.
CompanyDiscount to Intrinsic Value
1.Wesco Financial Corp.98.6
2.ECI Telecom Ltd.95.5
3.Koss Corp.92.8
4.Mesabi Trust CBI92.6
142 QUICK WAYS TO FIND STOCKS THAT BUFFETT MIGHT BUY5.Xeta Technologies92.0
6.Cohu Inc.91.5
7.W Holding Company91.1
8.American Power Conversion91.1
9.General Employment ENT87.0
10.Cognex Corp.86.6
11.Pre-Paid Legal Services86.4
12.D.R. Horton Inc.86.3
13.ILG Industries 85.6
14.Telefonos de Mexico SA L84.6
15.Jones Pharma Inc.83.6
16.Chittenden Corp.83.1
17.Orbotech Ltd. 83.1
18.Communications Systems Inc.83.0
19.Dell Computer Corp. 82.8
20.Royal Bancshares PA A81.6
David Braverman
Another person who has picked up the gauntlet is David Braverman,
a senior investment of?cer at Standard & Poor’s and the leading ana-
lyst who covers Berkshire.
Since Braverman began constructing such portfolios (in February
1995), the Buffett-like stocks he has chosen have returned 255 per-
cent (without dividends or transaction costs, through January 2001)
compared with only 174 percent for the S&P 500 Index.
Here are the ?ve criteria that Braverman used in screening the
10,000 stocks in the S&P Computstat data base:
1.High “owner earnings,” which is essentially free cash ?ow—net
income after taxes, plus depreciation and amortization of debt,
less capital expenditures. A company had to have at least $20
million in free cash ?ow.
2.A net pro?t margin of at least 15 percent.
3.A high return on equity, or net income (before payment of pre-
ferred dividends), as a percentage of the value of stock outstand-
ing. Braverman screened for a recent quarterly ROE over 15
percent, and an ROE of at least 15 percent for each of the past
three years. (Buffett considers pro?t growth relative to growth in
the capital base more meaningful than just growth in earnings.)
4.A high return on reinvested earnings. Each dollar of earnings
retained by the company should produce more than a dollar of
market value. To meet this test, Braverman looked for compa-
QUICK WAYS TO FIND STOCKS THAT BUFFETT MIGHT BUY 143nies whose growth in market capitalization surpassed growth
in retained earnings over the past ?ve years.
5.No overvalued stocks. Free cash ?ow was projected ?ve years
out, under the assumption that cash ?ow grows at the same
rate as earnings. To come up with a maximum valuation,
Braverman then divided the estimated free cash ?ow by the
current yield on the 30-year Treasury bond. Stocks selling
above their projected valuations were thrown out.
The stocks listed below are not necessarily those that Buffett
would buy. In choosing stocks, as mentioned, Buffett employs quali-
tative criteria as well—the nonmathematical as well as the mathe-
matical, the heart’s reasons as well as the head’s. Also, Braverman
did not eliminate technology stocks, like Microsoft, although Buffett
has steadfastly avoided them.
StockCurrent PriceCurrent P-E Ratio
AmeriCredit3515.2
Biogen684.5
Bristol-Myers Squibb6225.6
Brown & Brown39—
Citrix Systems2628.0
Dionex Corp.36—
Franklin Resources4116.7
Gannett Co.6717.4
Gentex Corp.25—
IPALCO Enterprises2414.1
John Nuveen55—
Lee Enterprises32—
Lincare Holdings5821.5
Linear Technology4331.2
Mackenzie Financial19—
MGIC Investment569.7
Microsoft6133.9
Oracle Corp.174.7
Orbotech38—
(T. Rowe) Price3615.7
SEI Investments4137.3
Tellabs4319.9
Verizon Communications 4815.2
Watson Pharmaceuticals5625.2
144 QUICK WAYS TO FIND STOCKS THAT BUFFETT MIGHT BUYCHAPTER 21
William J. Ruane
of Sequoia
What the Yankees are to baseball and what Beethoven is to sym-
phonic music, Sequoia is to the world of mutual funds. Simply
the best. If you had invested $10,000 in Sequoia in 1970, your money
would have been worth $1,315,850 at the close of the year 2000.
Since 1970 Sequoia has beaten the S&P 500 by an average of 2.7 per-
centage points a year. (See Figure 21.1.)
Alas, Sequoia bolted its door to new investors in the year King
John signed the Magna Carta (or maybe it was only as recently as
1982).
The chairman of the Sequoia Fund is William J. Ruane. Silver-
haired, fair skin, pleasant and charming, speaks slowly and carefully.
Easy to get along with.
145
William J. Ruane (Photo courtesy of Bachrach).Ruane’s of?ce is in the General Motors/Trump Building—on
59th Street and Fifth Avenue—with green marble and white mar-
ble in the lobby. Across the street from the Plaza, a la Vieille
Russe, FAO Schwarz, Bergdorf Goodman. Ruane’s 47th-?oor of-
?ce—simple and classic, much dark wood, no Quotron machine,
no Bloomberg—has a gorgeous view of Central Park and parts
north. Tasteful, conservative, interesting furniture. On an end
table is Roger Lowenstein’s biography of Warren Buffett. (It called
Ruane “a straight arrow.”) In a bookcase: James Kilpatrick’s biog-
raphy of Buffett, along with many investment books, stuff about
Harvard, photos of family, books by Adam Smith, a biography of
Bernard Baruch.
At 75 Ruane is still busy, still searching for good stocks; he divides
his time as well as he can, but puts his family ?rst. He’s chairman of
the board of Ruane, Cunniff & Co.; Richard T. Cunniff, 78, is vice
chairman; Bob Goldfarb, 56, is president and has been CEO for the
past three years.
A thread in our conversation: How impressed he is with Gold-
farb, who has been a partner for 30 years and who is, in Ruane’s
146 WILLIAM J. RUANE OF SEQUOIA
FIGURE 21.1 Sequoia Fund’s Performance, 1994–2001.
Source: StockCharts.com.estimation, the second-best money manager he has ever encoun-
tered. (No, he doesn’t know many other money managers person-
ally because “this wonderful candy store” he’s been running is not
in the Wall Street mainstream, but he reads about them.) “Buffett
has no peer in brilliance, but Bob Goldfarb’s next on my list,” Ru-
ane asserts. “He has the right approach and his talent is unique.
He’s a brilliant investor.”
Benjamin Graham, the legendary Columbia professor who wrote
the 1930s classic, Security Analysis, “provided the framework for
Bob and my thinking and approach, and for many others,” Ruane
says. “We have great respect for quantitative [math] analysis. Finan-
cial reports are critical; the numbers tell you so much. With the
amount of information made available by law, you can get an awfully
good idea of what a company’s about.”
Still, Philip Fisher, author of Common Stocks and Uncommon
Pro?ts, “brought in new dimension, and all of us have found it in-
structive.” Fisher (Chapter 5) argued that buying and holding blue-
chip stocks was a ?ne strategy.
Finally, Buffett’s teachings through his annual reports and so on
“have continually advanced the foundation of security analysis es-
tablished by Graham.
“In Graham’s day, the depression and after,” Ruane went on, “you
could ?nd lots of values by quantitative research—and it’s still true
to an extent. In the 1950s and 1960s, though, book value became
less important than the quality of earnings power—more determi-
nant of value.
I can’t emphasize that enough, that value as an entity also embraces
growth. People ask: Are you growth or value? People don’t fully appreci-
ate the fact that growth is absolutely part of the value equation. But value
is the ultimate yardstick.
What it’s all about is the market value of a stock. You multiply the price
of a share by all the shares outstanding, minus the preferred stock, then
calculate the real value, the intrinsic value, based on its earnings power.
And if the market value is below the intrinsic value, you’ve got it.
He himself will buy stocks that aren’t cheap. If a company has a
high growth rate, “I’ll pay up for it. Value may be the bottom line, but
growth is a factor. The quality of earnings matters.”
Ruane studied engineering during World War II in the U.S. Navy.
After the war, he found that his aptitude for the practical application
WILLIAM J. RUANE OF SEQUOIA 147of engineering, working for General Electric, was such that he was
not likely “to have a stellar career in that ?eld.”
He then went to Harvard Business School, where he studied under
George Bates, who used the “case method” (real-life examples, not
textbooks). “But Bates insisted that we read two books: Where Are
Their Customers’ Yachts? by Fred Schwed Jr. and Graham and
Dodd’s Security Analysis.”
Ruane began aiming for a career as a security research analyst and
eventually one of a money manager. He came to New York in 1949
and worked for Kidder, Peabody, “a great ?rm in those days.” As a
starter he was given three clients to handle—and a total of $15,000
to manage.
Then he learned that Ben Graham let outsiders audit his class at
Columbia. “I called up and they said ?ne—this was in 1950. It was a
seminar course, with 15 Columbia students and ?ve stockbrokers.”
Ruane ?rst met Buffett then; Buffett was taking the course.
“It was a great experience. The seminar was made completely fas-
cinating by the interplay between Ben and Warren Buffett, who to-
gether made the sparks ?y.”
What can he tell me about Graham? “I didn’t know him well, but
he was a wonderful teacher, bright and fair. One afternoon he
called me up for coffee; he was in New York on his way to Califor-
nia. He had read a book in Portuguese and liked it so much that he
wanted to translate it, so he dropped in on a publisher that day.
His interests were so diverse. He lived well, but not on a major
scale. He was not just a genius in the ?eld of economics, but he
was brilliant in many other ways and, on top of that, he was a very
kind guy.”
Didn’t Graham’s investment rules change over the years?
“The world changes, and you must change with it. There’s been a
shift from working capital to earning power as the prime determi-
nant of value. The current value of all future dividends, discounted
back. Clean earnings power. You look for stocks with a special
strength or niche or moat. You want growth that’s somewhat pre-
dictable over ?ve, eight or ten years. And after you’ve done that
much homework, why not own a lot of it? If your assumption was
right, you can continue to hold on.”
Like Ruane, Goldfarb went to Harvard; in 1971 he walked in the
front door looking for a job. “There were three or four of us then,
and we made him an employee. We had no doubt about him at all.
He’s been a major factor in the fund’s doing so well.”
148 WILLIAM J. RUANE OF SEQUOIAQuestions and Answers
Q. If I ever manage to get my hot little hands on one sniveling
share, can I buy more?
W.R. Yes. Unless you try to buy $1 million worth, as someone once
tried to.
Q. Will Sequoia ever reopen to new investors?
W.R. Very doubtful. We have a commitment to our board of direc-
tors that accepting additional money is not in our shareholders’ in-
terest. As it is, we don’t have enough good ideas to keep fully
invested. Even originally, money was coming in faster than we had
good ideas.
A ?ood of new money couldn’t be invested pro?tably—that’s one
reason the fund remains closed. Another reason: “Potential share-
holders of size want to see you and hear you, and that would take up
too much of our time.”
Ruane, Cunniff & Company now manages $4 billion–$5 billion in
private accounts as well as Sequoia, which has about $4 billion in
assets.
Sequoia is discriminating about the stocks it buys. “I believe in
concentration,” says Ruane, “and we bought just ?ve new stocks
in 2000.”
Sequoia is 33 percent invested in Berkshire Hathaway. “But we
didn’t buy it for 20 years—for various reasons. Then we looked at
it in 1989, took a good look at it, and decided that it was an attrac-
tive stock.”
We talked about the Trading Madness, the vast conspiracy to per-
suade the investing public to buy and sell as frequently as possible.
He mentioned watching CNBC, where “some people recommend
stocks selling at many times their growth rates and analysts predict-
ing 15 percent–20 percent growth for 20 or 30 years. It doesn’t hap-
pen in the real world.” He referred to an article by Carol Loomis in
an issue of Fortune providing evidence that hardly any companies
do that well regularly.
Q. Why all this turnover?
W.R. It isn’t just brokers who are out to make money. It’s also fu-
eled by an enormous frenzy by thousands of money managers
who are twisting and turning to try to be in the right place at the
QUESTIONS AND ANSWERS 149right time, with little thought of the underlying investment’s
merits.
Q. What mistakes have you made?
W.R. I’ve sold too early so many times. You should sell only when
there is a signi?cant change in a company’s fundamentals. You
know it when it comes along. But while the world changes, it
doesn’t change that much in ?ve-year periods. Wall Street will sell
a stock to a point where it’s way out of whack. For example, in the
late 70s, Gillette was selling at 6 or 7 times earnings. The p-e grew
to re?ect its basic fundamentals.
The 50s to the 80s were a great time; investors didn’t appreci-
ate the value of internal compounding. The arithmetic was fabu-
lous. Many companies selling at low p-e’s had a high return on
equity.
Sequoia’s golden years were the mid-70s. In 1975 the fund rose 62
percent, and in 1976 it rose 72 percent. After the horrendous bear
market of 1973–1974, he recalled, “Stocks were being given away.
“But more and more, stock prices became realistic. Their prices
became signi?cantly related to interest rates. I don’t think the mar-
ket is very overpriced now, but I’m not ?nding as much to buy. The
market was dirt cheap in ’78.”
Not that all investors are much wiser these days. With wonder-
ment in his voice, he mentioned that on March 1, 2001, the market
was down 210 points, yet it ended up higher. “It’s hard to know
what’s on some people’s minds as the pack ?ows one way and then
the other on any particular day.”
Q. Didn’t you once say that return on equity was the key clue that a
company was doing well?
W.R. Return on equity tells you how pro?table a company is, but it
doesn’t tell you if the company is static, what the opportunity is
for reinvesting its earnings for growth, for a continuing high rate
of return.
Q. What about index funds?
W.R. They’re wonderful for people, although a year ago when the
S&P was 30 percent in tech and tech was overpriced, that index
fund wasn’t the best place to be. Still, if you want to be in the mar-
ket and you have no particular knowledge (and it’s hard enough if
you do have particular knowledge), an index fund is probably the
best way to invest.
150 WILLIAM J. RUANE OF SEQUOIAQ. What about momentum investing? Buying securities that have
been going up?
W.R. It’s not investing.
Q. What other advice do you have for ordinary investors?
W.R. Put half your money into an index fund, and have the other
half in good three–four year bonds or Treasuries, and keep rolling
it over. You shouldn’t have to think about the quality of your bond
investments. If you’re not a pro, don’t fool about with those things.
He also urges investors to have a decent reserve fund, one that
will last three or four years. In Treasuries. “I really believe, as I get
along, that if you have a liberal reserve, you will continue to do intel-
ligent things with stocks even when you’re under pressure.”
Advice from Albert Hettinger of Lazard Freres
Says Bill Ruane, “I got some ?ne advice, which I treasure, in 1957
from a great mind: Albert Hettinger of Lazard Freres. He’s not well
known now, but he was one of the ?nest investors of the mid-cen-
tury. He had four general rules, which I’ve never forgotten.”
1.Don’t use margin. If you’re smart, you don’t have to borrow
money to make money. If you’re dumb, you may go broke.
2.Buy six or seven securities you know well. Have a concen-
trated portfolio. But don’t have only one or two securities.
3.Pay no attention to the level of the stock market. Concentrate
your attention on individual stocks. Market-timing has led to
enormous mistakes.
4.Beware of momentum. Stocks and markets tend to go to ex-
tremes both on the upside and the downside.
ADVICE FROM ALBERT HETTINGER OF LAZARD FRERES 151
Basics
Minimum Investment: Closed
Phone Number: 212-832-5280
Web Address: www.sequoiafund.comCHAPTER 22
Robert Hagstrom
of Legg Mason
Focus Trust
T
he Legg Mason Focus Trust Fund, managed by Robert G.
Hagstrom, was originally intended to closely re?ect Buffett’s in-
vestment strategy in a mutual fund, one with a low minimum ?rst in-
vestment. But as the fund has evolved, it seems to have moved more
toward the growth end of the spectrum, under the guidance of the
celebrated money manager Bill Miller, who runs various Legg Mason
funds.
Hagstrom, 41, has a B.A. and an M.A. from Villanova University. He
is a Chartered Financial Analyst and a money manager as well as the
author of excellent books on Buffett’s investment strategy, such as
The Warren Buffett Way (New York: John Wiley & Sons, 1995). As is
his wont, Buffett hasn’t commented on the books, but his partner,
Charlie Munger, has recommended them to Berkshire shareholders.
Hagstrom has also identi?ed the major mathematical criteria he be-
lieves that Buffett uses to screen stocks, and more than 100 of them
are listed on the Quicken web site. (See Chapter 20.)
The Focus Trust Fund began in 1996, the name apparently deriv-
ing from Buffett’s comment to Hagstrom that his is a “focus” portfo-
lio. At the time there were only a few concentrated funds, such as
Clipper, Longleaf Partners, Janus Twenty, and Sequoia.
When I ?rst interviewed Hagstrom, in 1995, he acknowledged that
153his fund wasn’t an exact replica of Berkshire’s stock portfolio. Focus
Trust owned shares of William Wrigley Jr., which Berkshire didn’t;
the fund didn’t own Coca-Cola or Gillette because “they’ve run up so
far.” Hagstrom was also avoiding UST, a favorite of Buffett’s: “The
possible liability lawsuits frighten us.” Among the entire areas that
Hagstrom was avoiding: technology.
A year after the fund was launched, assets were still only $20 mil-
lion. “Fortunately, I knew Bill Miller,” Hagstrom told me recently,
“and he agreed that Legg Mason was the perfect place to take a fo-
cus-type, low turnover fund.” In 1998 the fund changed its name to
Legg Mason Focus Trust.
With only 17 or so stocks, the fund is certainly concentrated. But
Hagstrom, unlike Buffett, has been willing to venture into technol-
ogy, and under Miller’s guidance he put one-third of Focus Trust into
New Economy-related stocks.
Thanks to the tech wreck, Focus Trust had a miserable 2000,
down 22 percent. But for the ?rst two, three, and four years of its ex-
istence it outperformed the S&P, quite an accomplishment consider-
ing how miserably other value funds had been faring and how
splendidly the growth-oriented S&P 500 had been performing. By the
end of 1999, in fact, Focus Trust had beaten the S&P 500 by 18 basis
points (0.18 percent) a year. The fund was also impressively tax-ef?-
cient, with a 98 percent score as opposed to only 96 percent for Van-
guard 500 Stock Index. (Investors kept 98 percent of their total
returns out of Uncle Sam’s clutches.) See Figure 22.1.
Questions and Answers
Q. What happened in 2000?
R.H. In 2000, we got clobbered. We were overweighted in technol-
ogy. We had nothing in oil, nothing in drugs, nothing in utilities
[sectors that excelled].
Q. Hasn’t Buffett himself become less and less of a Grahamite?
More and more a follower of Fisher—more growth-oriented?
R.H. This shift on Buffett’s part has been no doubt a result of the
in?uence of his partner, Charlie Munger. Still, Buffett continues to
seek a “margin of safety,” trying to buy assets cheaply, and zeroes
in on the companies he buys, not on what’s going on in the mar-
kets in general [“bottom up” and not “top down”]. He simply seeks
valuable businesses with favorable long-term prospects and capa-
ble managers. But low price-earnings ratios and low price-book
154 ROBERT HAGSTROM OF LEGG MASON FOCUS TRUSTratios, and high dividend yields, aren’t special concerns to him
now. That wasn’t characteristic of Graham. The Graham strat-
egy—low p-e ratios, low price to book—wasn’t consistently suc-
cessful after the 70s and early 80s.
Q. Can an ordinary investor truly emulate Buffett and do well by
buying only a handful of stocks?
R.H. If you concentrate on 15 or 20 good stocks with low turnover,
it’s my experience that you will do well. Your relative performance
will be dramatic. The trouble is that any investment strategy will
fade sometime, and ordinary investors, along with professionals,
will have their endurance tested.
QUESTIONS AND ANSWERS 155
FIGURE 22.1 Legg Mason’s Focus Trust’s Performance, July 1998–April 2001.
Source: StockCharts.com.
Basics
Minimum ?rst investment: $1,000 (it’s the same for IRAs).
Phone: (800) 822-5544.
Web Address: www.leggmason.com.Most fail. The in?uence of the market and other investors is so
great. Even if a money manager steadfastly carries the banner, his
or her followers may retreat.
Morningstar in January 2001 rated Legg Mason Focus Trust “aver-
age” compared with other stock funds, “below average” compared
with other large-blend funds. The fund was overweighted in retail, ?-
nancials, and technology. The turnover in 1999 was 14 percent, in
1998 21 percent, in 1997 14 percent, and in 1996 8 percent.
156 ROBERT HAGSTROM OF LEGG MASON FOCUS TRUSTCHAPTER 23
Louis A. Simpson
of GEICO
B
uffett has said that the person who might take over Berkshire
Hathaway when he leaves—he was 70 in the year 2001—is Louis
A. Simpson, 63, a reclusive value investor who has run GEICO’s in-
vestment portfolio since 1979.
Simpson, according to Buffett, invests in almost the same way he
does. “Lou takes the same conservative, concentrated approach to
investments that we do. ... ,” to quote Buffett. “His presence on the
scene assures us that Berkshire would have an extraordinary profes-
sional immediately available to handle its investments if something
were to happen to [Munger] and me.”
Unlike all the other investment managers who run Berkshire’s
subsidiaries, Simpson has a totally free hand, indicating how much
trust Buffett places in him.
157
Louis A. Simpson (Photo courtesy of GEICO).One can learn which stocks Simpson owns in his GEICO portfo-
lio by checking with A.M. Best, which rates and tracks insurance
companies.
Forbes magazine (October 10, 2000) has reported that Simpson is
a “slightly more daring investor—one who’s not afraid of tech buys
or portfolio turnover.” Most of the time his portfolio has trailed Buf-
fett’s, but not by much. In 1999, when tech stocks were in their glory,
Simpson’s portfolio actually did better.
From late 1979 into 1996, when GEICO was still traded publicly,
Simpson’s average yearly return was 22.8 percent versus Berk-
shire’s 26.5 percent—as against the Standard & Poor’s 500’s mere
15.7 percent. Using data from A.M. Best, Forbes estimated that
GEICO earned 17 percent in 1999, while Berkshire just about
broke even.
Simpson’s portfolio is more concentrated than Buffett’s, probably
because he has less money to invest—$2 billion versus $40 billion.
Recently Berkshire Hathaway owned twenty-eight stocks; GEICO,
only nine. According to Morningstar, the average large-cap value
fund owns 89. One of Simpson’s stocks, Shaw Communications,
even has a high p-e ratio, at 61.
Simpson also seems to buy and sell positions more frequently than
Berkshire, Forbes reports, although this, too, may be because of the
smaller size of his portfolio.
In 1999 Simpson bought two stocks, Jones Apparel and Shaw
Communications, representing almost a quarter of his entire portfo-
lio. He tossed out Manpower, the employment agency for temps. In
2000 he bought GATX and Dun & Bradstreet. In 1999 Berkshire also
bought some stocks, but they were small pickings—just 5 percent of
the portfolio.
In 1997 Simpson bought Arrow Electronics and Mattel; in 1998,
he sold them both. He bought TCA Cable in 1998 and sold it in
1999.
Whereas Buffett won’t buy technology stocks—he points out,
quite correctly, how dif?cult it is to identify today those compa-
nies that will be powerhouses ?ve or ten years from now—
Simpson has. But he has glommed onto seemingly cheap tech
stocks.
Berkshire in 2000 had half of its portfolio in the ?nancial sector;
Simpson was in the same ballpark, having 25 percent of his portfolio
in Freddie Mac and U.S. Bancorp.
Like Buffett, Simpson is a fanatic. He gobbles up ?nancial state-
158 LOUIS A. SIMPSON OF GEICOments and annual reports as if they were crime novels. And like Buf-
fett he’s sure of himself as far as investing goes. He, too, lives far
away from the madding Wall Street crowd—in Rancho Santa Fe, Cal-
ifornia, which is near San Diego.
Simpson was born in Chicago. He taught economics at Prince-
ton in the early 1960s, then moved to Shareholders Management,
a mutual fund run by the controversial Fred Carr. Simpson left
after a half-year, apparently because Shareholders Management’s
wildly risky investment strategy had landed the company into
hot water.
Ten years later he interviewed for the GEICO job. After Buffett
talked with him for four hours, Buffett said, according to Forbes,
“Stop the search. That’s the fella.”
He’s said of Simpson that he has “the ideal temperament for in-
vesting.” He “derived no particular pleasure from operating with or
against the crowd.” He has “consistently invested in undervalued
common stocks that, individually, were unlikely to present him with
a permanent loss and that, collectively, were close to risk free.”(Mar-
tin Whitman, the investor, claims that Buffett’s greatest strength is
his ability to identify good people.)
“Simpson seems to have the ideal temperament for Buffett,”
Robert Hagstrom told me. “He views stocks as businesses,
he wants to concentrate, and his portfolio has a low turnover.
And he doesn’t have any anxiety about his stocks being out of
favor.”
The heir apparent himself has outlined his investment strategy in a
GEICO report:
•“Think independently.” He’s skeptical of Wall Street; he reads
widely and voraciously.
•“Invest in high-return businesses for shareholders.” He wants
companies making money now and promising to continue mak-
ing money. He interviews management to make sure they are
shareholder friendly and not out to boost their incomes or their
self-esteem by creating empires.
•“Pay only a reasonable price, even for an excellent business.”
Even a splendid company is a bad investment, he believes, if the
price is too high. (Fisher might argue that the price of a splendid
company would have to be extremely high.)
•“Do not diversify excessively.”
LOUIS A. SIMPSON OF GEICO 159160 LOUIS A. SIMPSON OF GEICO
GEICO’s Recent Holdings
COMPANY/BUSINESSPRICE-EARNINGS RATIO
Dun & Bradstreet/?nancial rater31
First Data/credit card processing13
Freddie Mac/mortgage seller17
GATX/railcar leasing14
Great Lakes Chemical/chemicals12
Jones Apparel/clothing14
Nike/footwear19
Shaw Communications/cable TV61
U.S. Bancorp/banking11CHAPTER 24
Christopher Browne
of Tweedy, Browne
E
ven if someone is a Buffett buff, he or she may not know the name
of the stockbroker who bought shares of Berkshire Hathaway for
Warren Buffett.
The broker’s name was Howard Browne, of the ?rm that is
now known as Tweedy, Browne. It’s a ?ne old ?rm, and it still
practices Benjamin Graham-type investing, looking for (among
other things) cheap cigar butts that have a few good puffs left
in them.
The mutual funds the company runs, Tweedy, Browne American
Value and Tweedy, Browne Global Value, have commendable
records. In fact, Morningstar chose Global Value as its foreign fund
of the year for 2000.
161
Managing Directors, Tweedy, Browne (left to right): John Spears, Robert Wyckoff,
Christopher Browne, Thomas Schrager, William Browne (Photo courtesy of Tweedy,
Browne).The family itself is different from other fund families for a variety
of reasons.
•There are only two funds in the family—no sector funds, no
?xed-income funds, no “market-neutral” funds, no funds du
jour.
•Tweedy, Browne sticks to its knitting. The stocks of both funds
have price-earnings ratios and price-book ratios far below the
average Standard & Poor’s 500 stock. Neither fund, naturally,
has more than a trace of technology stocks.
•The fund family has a colorful history. It was launched as a bro-
kerage ?rm in 1920 by Forrest Berwind Tweedy, and for years
its biggest customer was no less than Ben Graham.
Another customer, later on, was Buffett, a student of Graham’s at
Columbia, who bought most of his shares of Berkshire Hathaway
through Howard Browne, father of the two Brownes who run the
fund today. (A third manager is John Spears.)
Howard Browne even gave Buffett desk space. Buffett would drop
in and sip a soft drink—no, not Coca-Cola but Pepsi.
Buffett asked all his brokers not to buy the stocks he was buying.
(If they did, that would raise a stock’s price, forcing Buffett to pay
more for the stock later on.) Apparently Browne’s father was one of
very few who listened.
Something else different about Tweedy, Browne: The managers
are intellectuals. They study the academic data about investing.
They have even published some splendid pamphlets: “What Has
Worked in Investing” (answer: undervalued stocks) and “Ten Ways
to Beat an Index” (a key way: buy and hold undervalued stocks).
They even have an essay on how to invest like Warren Buffett. (See
Chapter 9.)
Beyond that, Chris Browne just happens to be a felicitous writer.
A taste: “As we have said in the past, we love technology, but we
just don’t love technology stocks. We also have a Web page,
www.Tweedy.com, where we post any news about the ?rm.... A
Web poacher took www.TweedyBrowne.com. We were too cheap
to ransom it back.” (But it’s back anyway.)
The company’s of?ces are on Park Avenue in New York City.
Interviews with the shrewd and urbane Chris Browne, 53, are a
pleasure.
162 CHRISTOPHER BROWNE OF TWEEDY, BROWNEQuestions and Answers
Q. Why do growth and value stocks alternate days in the sun?
C.B. Those terms are hard to de?ne. Growth guys claim that they
buy all the neat companies and all the technology companies
growing wonderfully. They say that we value guys invest in the
hospice patients of corporate America. Rust-belt stuff. But Warren
Buffett said that value and growth are joined at the hip. And the
best growth people are also value people.
A lot of people who call themselves growth players buy stocks
that are hard to value. Fiber-optic cable makers, for example. The
whole technology market in recent years.
Sanford Bernstein did a study of pharmaceutical companies
and technology companies during the past 20 years and found
that they had the same long-term rates of return. The difference
was that the technology leaders kept changing, but the pharma-
ceutical leaders remained the same. Technology stocks are far
more likely to crash and burn. Everyone expects them to be so
perfect, and with the least disappointment they’re down 20, 30,
60 percent.
Some people confuse growth investing with momentum invest-
ing, where, if it’s been going up, you buy it. But when the music
stops, the question is whether you’ll get a chair.
Everyone jumps onto the bandwagon; money gravitates to what
has performed best recently. Nothing else explains the dot.com
phenomenon. There was no fundamental ?nancial reason for buy-
ing these stocks. And when they began to run out of cash, it
caused the collapse.
You can buy and hold drug stocks for 10 or 20 years, but not
tech stocks—except for IBM and Hewlett-Packard. It’s dif?cult for
tech stocks to defend their market position. Someone is always in-
venting something that goes twice as fast. These companies have
to reinvent themselves every 10 years, but Coca-Cola makes Coke,
and that’s it.
Q. How do you choose value stocks?
C.B. To insulate us, we track purchases by company of?cers. We
rate people who buy in importance, too: more if it’s the chairman
or the chief ?nancial of?cer, less if it’s an outside director. Ideally,
we see a reasonable price-book ratio, a reasonable price-earnings
ratio, and insiders accumulating shares.
QUESTIONS AND ANSWERS 163We also follow the leads of smart people. Years ago, Wells Fargo
was selling for $65 a share with no earnings. The Federal Reserve
wouldn’t believe that the bank had no problems with its real-es-
tate loans, so the Fed had made the bank set aside extra reserves.
That wiped out the earnings. Two respected bank analysts had to-
tally different opinions: One said the bank’s loans would blow up,
the other said that idea was absurd. We didn’t know whom to be-
lieve. Then Warren Buffett bought $600 million worth of shares.
He didn’t phone us to tip us off; but the news that he was buying
was better than a phone call.
In 1993 Johnson & Johnson was selling at only 12 times earnings
when Hillary-care was threatening the pharmaceutical industry.
Then Tom Murphy at Capital Cities, a director at J&J, bought
nearly 40,000 shares. We decided to make a signi?cant invest-
ment—and we made good pro?ts.
In general, it’s better to be lucky than smart.
Q. What about Pharmacia? That’s in both your portfolios.
C.B. It’s had all sorts of problems. But it has the lowest ratio of
price to sales of any major pharmaceutical. And they have
enough white coats doing research, they’re bound to ?nd some-
thing. When Fred Hassan came over from American Home to
take over Pharmacia, he and other key insiders bought more
than 100,000 shares personally. We put this fact-set together and
bought.
In general, we’ve found that if you pay attention to academic
studies of stock market truths, plus particular fact-sets, plus
you have a diversi?ed portfolio, you’ll have satisfactory rates of
return.
Not many people pay attention to what has worked in the
stock market—things like low price-earnings ratios, low price-
book ratios, and the high price you might get in an open auction
for the entire company. It’s not that it’s dif?cult to ?gure out.
It’s like pricing a house. What have similar houses been going
for?
As value investors, our focus isn’t on buying stocks that may
beat the estimates by a penny.
Value people aren’t the kind of guys you go drinking with.
They’re eccentric. Opinionated.
Growth people are all over the landscape in terms of investing.
Will the drug sector do well over three weeks or not? They don’t
164 CHRISTOPHER BROWNE OF TWEEDY, BROWNEhave strong opinions about anything. They don’t adhere to princi-
ples. But they’re good people to go out drinking with.
Growth investors may wind up with a lot of short-term capital
gains. We have long-term gains. We held Johnson & Johnson for
more than six years. We’d like to hold our stocks forever. We’re bi-
ased toward nontaxable gains. Buffett is a good example: He
never sells anything.
The three of us [C.B. and managers William H. Browne and John
D. Spears] have $400 million of our own money in the stocks that
our clients own and in the funds themselves. For us, April 15 is a
national day of mourning.
We accept the fact that as value managers we’ll have down pe-
riods, but over 20-year periods we’ll be winners. The chances of
hedge-fund jockeys beating the index over the next quarter for
the next 20 years are pretty slim. They’re inclined to confuse
luck with intelligence.
We pay more attention to what we can actually accomplish.
We look at the empirical data. There’s little empiricism in this
business.
Others sit down at a desk and ask themselves, What shall we
buy or sell today? They’re business types, looking for new prod-
ucts. If XYZ stock has faltered for three quarters, they’re out of
there. And because they work for someone else, they might be
?red.
We stick to our guns. We don’t have bosses who can ?re us. The
only people who can ?re us are our clients.
Warren Buffett answers to no one. He can’t be ?red. He can do
whatever the hell he wants.
Q. How does Buffett’s strategy differ from Tweedy, Browne’s?
C.B. We don’t make as large a bet. We’re more diversi?ed. We have
less con?dence in our ability. Besides, if we weren’t as diversi?ed
as we are, we could lose our accounts.
Q. What do you think of Buffett’s strategy of buying good compa-
nies and owning them forever?
C.B. Buy blue chips? It sounds nice. Yet Lucent and AT&T were
blue chips, and look at them now. Lucent is going to have to rein-
vent itself. Who knows?
The question Buffett asks is, Could I own this stock for ten
years? If I were locked into a stock, what would I buy? I’d say
QUESTIONS AND ANSWERS 165some of pharmaceuticals, like Johnson & Johnson. Buffett wants
a company with a moat around it, and Johnson & Johnson has a
moat. No one is about to replace Band-Aids.
Q. What about Philip Morris stock? That wasn’t a stock to buy and
hold forever.
C.B. We got rid of it. It’s not subject to market analysis. Who
knows what will happen with the court system? It’s got a nice, ad-
dictive product, it’s cheap, and it does well in developing coun-
tries. When people in a developing country become af?uent, they
buy the best brand names: Coca-Cola and Marlboro. But as far as
we’re concerned, we’d rather buy something else.
Q. What do you think of index funds?
C.B. They’re dif?cult to beat—both pre-tax and even more on an
after-tax basis. But at this point, the S&P 500 is so tech oriented
and so overweighted in a few stocks. No one creates a portfolio in
terms of the weightings of an index. That skews the returns dra-
matically—?ve or ten stocks have been accounting for almost all
of the returns.
Q. Why has your global fund been doing better than your U.S.
fund?
C.B. In our U.S. fund, we don’t have much in technology stocks—
just telecoms. That has hurt us. Abroad, there are crazy indexes.
The Swedish index is half Nokia. Five stocks make up 80 percent
of the Dutch index. It’s really wacko.
In our foreign fund, we have only 11 percent in U.S. stocks.
And we’re 100 percent hedged. We don’t try to predict currency
movements.
Q. What mistakes have you made?
C.B. Even if a stock ?ts your pro?le and you have good diversi?ca-
tion, sometimes you run into a wall. It happens. The most dif?cult
thing is, when you have negative news, to try to examine the stock
on its new fundamentals. If it’s still selling at a discount, we’ll hang
on. But if we think a lot more bad news may be coming, we’ll get
out. We tend to be not as forward thinking as growth managers.
Value people tend to focus on the here and now as opposed to
making predictions.
I sit on other boards, and the chairmen may say earnings will be
43 cents a share this quarter, and two weeks later it turns out to be
27 cents a share. They don’t know.
166 CHRISTOPHER BROWNE OF TWEEDY, BROWNEGod’s the only great predictor, and he’s not talking to many of
us. And those who do talk to God don’t ask the right questions.
Q. If you had to choose one stock to own for 20 years, what would
it be? Johnson & Johnson?
C.B. As a game, we ask ourselves that. But we don’t act on it. I
can’t tell you exactly, but it would probably be in the pharmaceuti-
cal industry. Look at the demographics, look at the rates of discov-
ery in biomedical science. I’m on the board of Rockefeller
University, and biotechnology research is very exciting. Research
time is getting compressed.
In technology, obsolescence may take six months. In 1970 we
bought a hand-held calculator for $350. It weighed three pounds. It
had memory. Two years later, the company that made those calcu-
lators was in bankruptcy and Hewlett-Packard was giving calcula-
tors away as Christmas presents. Today, PalmPilots are
wonderful, but the cost will have to come down. When Bill Gates
starts making them, the price will go down and down.
Q. Why do so many investors make mistakes?
C.B. People tend to value action rather than inaction. That’s why
women are more successful investors than men. They’re more
cautious. They buy and sell less than men, and they get better
results. Turnover is inversely related to investment results. Port-
folio managers are always buying and selling stuff. They think
they’re making intelligent decisions, but the data suggest
otherwise.
People feel that they must be doing something to justify their
existence. Even if they don’t feel that way, the people they report
to feel that way. “No changes this month? What are we paying you
for?”
Some people make a killing, and other people think they can,
too—it’s the con?dence factor. Everyone thinks they will win the
lottery, despite the fact that ?ve million tickets are sold. It’s pa-
thetic, but they do.
There’s so much noise, so much instant information, and people
always react. We ourselves say, “That’s nice, but not relevant.”
Other people buy at 10 A.M.and sell at 11 A.M.They make four
points on the round-trip.
At other mutual funds, their results are compared to a bench-
mark, an index. So they feel that they have to be diversi?ed like
the index, always to have to be 10 percent in oils. We ourselves ig-
nore industry categories.
QUESTIONS AND ANSWERS 167Q. Have you ever been asked to put together a concentrated port-
folio?
C.B. Yes, but when we try to identify the best stocks in our portfo-
lio, we’re always wrong. They’re the ones that decline. So we ?nd
it very easy not to try to do what we know we can’t do.
The American Value Fund
The American Value fund, launched in 1993, is unusually stable. Its
beta is 0.77, meaning that it ?uctuates only 77 percent as much as
the S&P 500. Morningstar rates it “below average” for risk. The
fund trades infrequently: Its turnover is usually less than 20 per-
cent a year. (In 1995, it was 4 percent.) The fund’s long-term
record, Morningstar reports, “is solid, suggesting that this offering
is a good option for investors with growth-heavy portfolios.” (See
Figure 24.1.)
Tweedy, Browne Global Value is a little less volatile than its U.S.
counterpart, with a standard deviation of 15.9 versus 16.87. Its ?ve-
year record is also better: 19.13 percent a year versus 16.75 percent.
The fund also has much more in the way of assets: $3.557 billion. As-
sets are heavily invested in Europe (42 percent), with only 12 per-
cent in U.S. stocks
The funds share some of the same stocks.
168 CHRISTOPHER BROWNE OF TWEEDY, BROWNE
FIGURE 24.1 Tweedy, Browne American Value Fund’s Performance, July 1995–August
2001.
Source: StockCharts.com.THE AMERICAN VALUE FUND 169
Basics
Minimum Investment: $2,500
Phone: (800) 432-4789
Web Address: www.TweedyBrowne.com
Fees: These funds are no-load funds.CHAPTER 25
Martin J. Whitman
of the Third
Avenue Funds
I
asked Marty Whitman how his investment strategy differs from
Buffett’s—Whitman has known Buffett for 25 or so years.
“He’s a control investor,” he replied. He owns 100 percent of some
of his companies, like See’s Candy; he’s an active member of the
board of directors of certain companies that Berkshire has a large
stake in, like Coca-Cola and Gillette. He recently approved of a
change in the CEOs of both companies.
“We at Third Avenue,” said Whitman, “are just passive investors.
Not that we aren’t in?uential.”
171
Martin J. Whitman (Photo courtesy
of Third Avenue Funds).What are Buffett’s special gifts? “Of all the people I know,” replied
Whitman, “he has the most uncanny insights into people. He’s an un-
believably good judge of people. It’s a great talent. And he’s a good ?-
nancial guy, too.”
How is Whitman himself at evaluating people? “I screw up.
Boy!”
Whitman, a white-haired gentleman in his 70s, has a pleasant man-
ner, a sweet smile, a fresh sense of humor, and a razor-sharp mind.
He’s outspoken, too—a journalist’s dream.
At a Morningstar conference not long ago, he listened attentively
while a youthful journalist recommended that everyone just invest in
index funds. Value managers don’t like to hear that. Marty was the
next speaker. “I don’t know who that young guy was,” he said
sweetly, referring to the Wall Street Journal writer, “but he’s a com-
plete idiot.” Vintage Whitman. (Whitman rightly saw that the S&P
500, dominated by high-priced big-capitalization stocks, would fall
into a deep hole in the year 2000.)
Another time, visiting New Jersey to give a talk, he and his driver
got lost, although they managed to arrive at the lecture hall in time.
He told the audience, “Finding good undervalued companies is
hard, but ?nding Route 4 from the George Washington Bridge is
sheer murder.”
Another way Whitman and Buffett differ: “He won’t do high tech,
and I do a lot of high tech. We’re both right. Tech has a high failure
rate, a high strikeout rate. But when we do tech, we do 12–14
stocks among semiconductors—and that’s very tough for a control
guy,” someone who wants to micromanage his portfolio. “I made a
fortune in semiconductors, something he wouldn’t touch. We knew
going in that there might be dogs,” but that’s why they bought 12 or
14 of them.
Early in his career, Whitman went into bank and shareholder liti-
gation—“a great training ground.” He became interested in closed-
end funds, and went after Equity Strategies, a fund whose net asset
value was far below its intrinsic value, what the individual holdings
in the fund were really worth. He took it over and opened it up, real-
izing the appreciation. “That’s something people can’t do these
days,” he said, “because of legal restrictions the closed-end funds
have set up.”
He’s taught at the Yale School of Business for years, and recently
began teaching at Columbia.
During a wide-ranging conversation in his of?ce, Whitman told me
172 MARTIN J. WHITMAN OF THE THIRD AVENUE FUNDSthat “it’s ordained that some of your stocks won’t do well. There are
a lot of disappointments.” He was wearing a purple sports shirt,
slacks, and beaten-up sneakers—placed atop his desk. What the
heck, it’s his of?ce and his company.
Questions and Answers
Q. What causes most of your own mistakes?
M.W. Faulty appraisals of management’s abilities. We can really
screw up. Assessing people happens to be Buffett’s great strength.
I know Buffett, and he’s not such a genius. He doesn’t know as
much about ?nance as I do. But he’s a great judge of people, espe-
cially management people. He’ll agree with that.
Like many other value investors, Marty has little but contempt for
growth investors. As he sees it, they buy high-priced stocks, wait un-
til the market goes nuts and those stocks become even more high-
priced—then sell.
M.W. The inmates are running the insane asylum. All “value”
means is being price-conscious. Growth investors ignore the
price, and put their weight on the outlook—speculating on the
great times ahead.
A principal reason why value stocks in the long run do better
than growth stocks is that you don’t need a crazy stock market to
bail you out. There can be mergers, buyouts, acquisitions—and
you make money. That’s why Alan Greenspan and the economy
are “irrelevant”: All you need do is buy good stocks cheap—and
hang on. We ignore market risk.
Third Avenue Value was going great guns in 2000 because Whit-
man bought semiconductor stocks in 1997 and 1998, when they were
ridiculously cheap. Otherwise, most of his portfolio wasn’t doing
much: “Sixty percent of it sucks, price-wise.” See Figure 25.1.
He adds another reason why his portfolio is beating the band: “I’ll
spell it out. L-u-c-k.”
Whitman, who’s been in the business for nearly 50 years, likes to
contradict people—perhaps that comes with the value territory, buy-
ing stocks that almost everyone else despises.
Q. Doesn’t a value investor need lots of patience?
QUESTIONS AND ANSWERS 173M.W. With individual stocks, maybe, but not with your entire port-
folio if you’re doing it right. Some of your stocks will be basking in
the sun. I’ve never lost a night’s sleep.
Q You’re not a big fan of index funds?
M.W. It’s far superior to speculating. But it’s not as good as intelli-
gent value investing. It’s not even close.
For novice investors, I recommend mutual funds, where it’s
hard for investors to get roundly abused. And the part I like best,
the promoters can get ?lthy rich. It’s like having a toll booth on the
George Washington Bridge. All cash—and you don’t have to work
very hard.
I suggest that the average investor buy a leading value fund,
like Mutual Shares, Gabelli, Oakmark, Longleaf, Royce, or
Tweedy, Browne. In all the years I’ve been in business the out-
side passive investor is always getting taken to the cleaners.
IPOs. Tax shelters. Junk bonds. They buy what’s popular. And
that’s a death sentence.
Q. What one stock would you recommend that a person buy and
hold forever?
M.W. Capital Southwest, a diversi?ed business development com-
pany run by someone I admire, Bill Thomas. I expect it to grow by
20 percent a year.
174 MARTIN J. WHITMAN OF THE THIRD AVENUE FUNDS
FIGURE 25.1 Third Avenue Value Fund’s Performance, 1994–2001.
Source: StockCharts.com.Q. What investment book would you recommend? Besides your
own book, Value Investing?
M.W. Trouble is, no book emphasizes the quality of a company’s
resources before the quantity. Or advises people to buy cheap
rather than to predict prices. To look for the absence of liabili-
ties. And a generous free cash ?ow and other signs of strong
?nancials.
Q. What really good question did I fail to ask you?
M.W. The advice I give kids at Yale who want to go into the ?eld:
Get training in an investment bank, in public accounting, as a pri-
vate placement lender, or as a commercial lender. Learn the guts
of the business.
Q. How important is the p-e ratio when you assess a stock?
M.W. Toyoda Automatic Loom Works has tremendous assets in se-
curities, including Toyota, the auto company. Yet leading analysts
writing about Toyoda ignore the assets and write about the high p-
e ratio. Their brains are not in the usual biological place.
QUESTIONS AND ANSWERS 175
Basics
Minimum First Investment: $1,000
Phone Number: (800) 443-1021
Web Address: www.mjwhitman.com/third.htm
Fees: This is a no-load fund.CHAPTER 26
Walter Schloss of
Walter & Edwin
Schloss Associates
Wrecord is powerful evidence that value investing is a sensible
strategy. Schloss has been managing money since 1955. In that span,
his investments have risen 15.7 percent a year; the Standard & Poor’s
Industrial Average (not the 500 Index) has climbed only 11.2 percent
a year.
At age 84, Schloss still comes to work every day, sharing an of-
?ce with the Tweedy, Browne folks on Park Avenue in New York
City. When he and Christopher Browne go out to lunch, Browne—a
man in his early 50s—has to quicken his step to keep up. And in an
interview with me, Schloss was full of beans, quick thinking and
177
Walter Schloss (Photo courtesy of John
Abbott).
alter J. Schloss worked as an analyst for Graham himself, and his
Image intentionally excluded from the electronic edition of this book.contentious—for example, dismissing the naive notion that anyone
should buy and hold stocks inde?nitely (I had said that ordinary in-
vestors might learn that from Buffett), denigrating index funds, and
scolding me for mistakenly referring to Bill Ruane, who started the
Sequoia Fund, as Charles.
Schloss is nowhere near so famous as Graham’s most notable
pupil, with whom Schloss shared an of?ce when both worked for
Graham back in 1957. Contented with his role in life, Schloss has
never tried to make his ?rm especially large.
He and the Sage of Omaha remain friends. At ?rst Schloss was du-
bious about letting me interview him. Then he decided, “I’ll check
with Warren.” An hour later, he called me back: Buffett had told him
that he didn’t mind.
Like Graham, Schloss looks for good companies with cheap
stocks, and he focuses almost exclusively on the numbers. He dis-
couraged me from visiting him in person—he was busy, and didn’t
want me to make the trip—so I spoke to him on the phone.
Questions and Answers
Q. Benjamin Graham, I gather, was very much in?uenced by the
crash of 1929 and the depression that followed.
W.S. Yes, the crash affected him a lot because he had spent a lot of
money and suddenly he wasn’t making any.
Q. Graham and Buffett never forgot how treacherous the stock
market could be.
W.S. Yes, and Warren’s father, too. His father was a stockbroker. I
think he inherited that fear—a lot of us did.
Q. People don’t remember much about the crash years.
W.S. They don’t want to.
Q. 1929 wasn’t actually that bad a year. The market was down only
17 percent.
W.S. It was if you had bought on margin, which people were doing as
if they were the high-tech stocks of today. You could buy on margin
with only 10 percent, so if the market went down a little bit, you
could be wiped out. Stocks that might have been 90 went down to 2.
Now we have margin of 50 percent, but even with that specula-
tors lost a lot of money with high-tech stocks. The stock market
went back up at the end of 1929, then went down in March of
1930. It was a bear trap.
178 WALTER SCHLOSS OF WALTER & EDWIN SCHLOSS ASSOCIATESQ. I think Ben Graham fell into that trap.
W.S. I don’t know. ... But you learn by doing.
Q. Graham’s rules for investing changed over the years, didn’t
they?
W.S. We live in a society that changes, so you can’t be too strict
about the rules you had 40 or 50 years ago. You can’t buy stocks on
the basis you did then. We would buy companies selling for less
than their working capital, but now you can’t do it. Those compa-
nies would get taken over. We use book value now.
Q. And other investors discover those cheap stocks, too?
W.S. You have 40,000–50,000 Chartered Financial Analysts looking
for those stocks. I have a friend who came out of the Harvard
Business School in 1949, I think it was, and he said that out of the
whole class only four people went down to Wall Street. In the last
couple of years, 80 percent or 90 percent went down to Wall
Street.
Q. Do you think book value is the single best way to estimate the
intrinsic value of a company?
W.S. No, no, I don’t think it’s the only way. It’s a factor, though. The
problem is, even if there’s book value, a company may not really
be worth a lot—a big old plant might be hard to sell, for example.
The thing I would watch for is debt. If you look at the companies
in trouble, like Xerox or Chiquita Banana, these companies had a
lot of debt. And then when things go bad and they need more
money, the fellows who lend money get scared and say, We don’t
want to lend you money any more. So what are they going to do,
sell their plant? So I think that debt is one of the most important
things to look for.
Q. Charles Ruane [another Graham disciple] has said that return
on equity may be the most important factor.
W.S. He may be right. But his name is Bill, not Charles.
Q. That’s what we journalists specialize in—getting names wrong.
What purchases have you made over the years that you did espe-
cially well with?
W.S. We don’t discuss what we’ve bought. Warren has to tell the
SEC what he’s bought and sold every year, so he has a year to ac-
cumulate stock [before the public ?nds out]. But we don’t talk
about what we’re buying or what we’ve bought.
QUESTIONS AND ANSWERS 179Q. Do you totally ignore how good a company’s managers are, or—
W.S. I can’t evaluate management. Theoretically, management is in
the price of a stock. If it’s a good company with good manage-
ment, the stock sells at a high p-e. If the management is poor and
people don’t like the company, it sells at a lower p-e. And some-
times it’s just in a bad industry. But I can’t evaluate management.
The price of a company may be a re?ection of the way people
think about the whole company at that particular point. You can
look at management and you might say it’s good because the stock
is doing nicely with a good pro?t margin. We’re a small investment
company; we don’t have time to go around talking to the people,
talking to their competitors.
Q. What’s the most common mistake that ordinary investors seem
to make?
W.S. I think people trade too much, looking for short-term gains.
But I don’t think you should hold stocks inde?nitely.
Q. You told me that you sold Bethlehem Steel ...
W.S. It was selling at $37, and I sold it to buy this Western Paci?c.
At the time, Bethlehem Steel was in the Dow Jones Average. I
think it’s at $3 now. Western Paci?c went out at around $163. So
you can’t just say that you’re going to buy the good companies
and hang onto them all the time. That sounds all right, but you
might as well buy Berkshire Hathaway and let Warren worry
about it.
But I don’t think you should even be writing about the stock
market. We’ve had a great bull market for 18 years; you’ll never
see a bull market like this again.
Q. Don’t you think people can learn something valuable about in-
vesting from Buffett and other value investors?
W.S. If they haven’t learned by now, I don’t think they’ll ever learn.
Q. Why do you have doubts about investing in index funds?
W.S. Because all you’re saying is that you’ll do as well as the mar-
ket. That’s not what you’re really supposed to be doing. You’re giv-
ing up. You’re just saying, Okay, I’ll do what the market does,
period. You might be right, but then you have to value the stocks
in the index—if you really want to be intelligent about it. You
might say, these stocks are selling at a high price in relation to
what I think they’re worth, and if you think they’re selling at a high
price, it wouldn’t be a good idea to buy an index fund. You’re going
to have to evaluate the market yourself.
180 WALTER SCHLOSS OF WALTER & EDWIN SCHLOSS ASSOCIATESQ. But you don’t engage in any market-timing—
W.S. No, I’m not interested in timing.
Q. But if you didn’t ?nd anything worth buying, you’d sit in cash?
W.S. Yes.
Q. Why do value and growth investing seem to take turns basking
in the sun or skulking in shadows?
W.S. That’s a good question, and I don’t know, and I won’t even
think about it, to tell the truth. I don’t really care. But you get
trends, and people want to do things, and suddenly they get into a
mania, about growth stocks or high-tech stocks, and then they go
in, and they don’t work out, and then someone says, I think you
should buy value stocks, and they do that for a while—I don’t
know the motivation.
People are sort of in?uenced by, I guess, CNBC, where these
guys are touting stocks. They rarely tell you to sell stocks. And
the brokers do another thing, of course, which is human nature—
they recommend stocks that are going up because if you recom-
mended a stock that was going down, and it kept going down, the
customer would be unhappy with it. But if a stock is going up,
everyone is happy with it because you’re buying a stock that’s do-
ing nicely.
Q. Your investment style is very close to Ben Graham’s, isn’t it?
W.S. I try to be close to Graham in style. Ben Graham wasn’t fo-
cused entirely on the stock market. He was a brilliant guy; he was
able to translate Greek and Latin and all that. But investing was a
challenge for him, and he met the challenge by writing books. And
I think The Intelligent Investor is a great book, and if you were to
tell people to read it, that would be a very good thing to do.
Q. Why has Warren Buffett been so successful?
W.S. Well, he’s a very good judge of businesses, particularly ?nan-
cial businesses. You’ll notice that a great deal of his money is in
American Express, the banks, Wells Fargo, Freddie Mac. He’s got
companies where he can kind of project what they will do. But
with industrial companies, the kind that we invest in, particularly
the cyclical companies, you can’t do that so easily. You have a
good year, and then the next year is bad. Banks have been getting
more and more money, and other industries have been cutting
back. The textile industry has been destroyed. Coca-Cola is having
a few bad years. How high is up?
QUESTIONS AND ANSWERS 181I think Warren feels more comfortable owning ?nancial compa-
nies. GEICO is another one of his ?nancial companies. Warren is
extremely good at making investments in companies where he can
project what they’ll do 10 years from now.
Q. Of every 10 stocks you buy, how many work out well and how
many don’t?
W.S. I don’t know. I’d say about 80 percent work out. I don’t really
know.
Q. It can take four years for a company to work out?
W.S. On the average. That’s not true of every company. If a com-
pany is having trouble, it may take six years to work out. And
sometimes you buy a stock and it sort of catches ?re, or some-
body takes it over. And you didn’t know that would happen. You
get some lucky breaks and you get some poor breaks. Sort of a
law of averages.
Q. You invest in what sized companies? Mid-caps?
W.S. Mid-caps and smaller rather than big companies. The big
companies have been sort of pawed over by all the analysts. The
analysts look at the 150 or 200 largest companies. If you’re manag-
ing $50 billion, you can’t fool around with buying a small company,
where you might be able to buy only $100 million worth of stock.
As for the high-tech companies, they’re mostly small, but the spec-
ulation was that they had a great future. Well, maybe they do and
maybe they don’t, I’m not smart enough to know.
Q. Why are you in such good all-around health?
W.S. My father. My job in life is to beat my father. He was 103 when
he died. Actually, I think it’s just a genetic thing. I’m just very for-
tunate that I have some of his genes.
Q. Can you tell me more about yourself?
W.S. I like playing bridge and tennis, and I like the theater. We’re
New Yorkers, we were born in New York. It is a very stimulating
place, it has a lot of museums. Anybody can do anything they want
in New York; there are a lot of different alternatives. Some people
don’t like that. They like a quiet area where there isn’t all that pres-
sure. I don’t mind the pressure. I kind of like it actually.
We’re a low-key company; we’re not a big company. I didn’t
want to be a big company, I didn’t want to have a big staff, I didn’t
want the responsibility of hiring people and ?ring people. I wanted
182 WALTER SCHLOSS OF WALTER & EDWIN SCHLOSS ASSOCIATESto keep my life simple. But I love working with my son, Edwin. We
make a good team.
I came to Wall Street in 1934. In those years, there wasn’t
much going on. And then the war broke out and I spent four
years in the army, and then I worked for Ben Graham for nine
and a half years. So I’ve been around a long time, and it’s been an
interesting run.
QUESTIONS AND ANSWERS 183CHAPTER 27
Robert Torray of
the Torray Fund
B
ob Torray and an investor who has had a decisive in?uence on
Warren Buffett, Phil Fisher, seem to be blood brothers. They be-
lieve in buying ?ne companies when they’re not especially expen-
sive, then holding on and on.
Yet Torray has never read Phil Fisher’s writings, although “I’m
aware of him,” he told me. “I’m keen on being my own guy.”
The only investor whose opinion he values, he said, is his partner,
Doug Eby.
Still, “Warren Buffett, whom I don’t know, has had a profound
effect on my thinking. No other investor can match his insight, hu-
mility, and accomplishments. There are others who have made a
lot of money, especially in the tech area, but I believe they’re not
as well situated for the long haul. In most cases, their fortunes are
185
Robert Torray (Photo courtesy of
William K. Geiger).tied to a single company. Things change—we see it every day. A lot
of single-stock fortunes have evaporated recently, and it’s likely
there will be more. I don’t see a chance of that happening at Berk-
shire. It owns too many businesses, and the ones that count are
very solid.”
An Unconventional Background
Torray’s background is not what one would expect in a money man-
ager. He majored in history at Duke University, getting his B.A. in
1959. He then went to law school for a year and a half, and clerked
for a law ?rm that did work for the Securities and Exchange Com-
mission. His boss there talked a good deal about stocks, and that
made Torray interested.
He began working as a stockbroker for Alex. Brown and Sons in
Baltimore in 1962, quickly moving over to managing pension funds,
in Washington, D.C. In 1967 he went to Eastman Dillon Union Securi-
ties, in New York City, now part of PaineWebber. He founded his
own ?rm in 1972, in Bethesda, Maryland. He opened the Torray Fund
in 1991. (See Figure 27.1.)
At the beginning he invested in obscure, little-known companies,
turnarounds, special situations, taking advantage of market cycles.
A specialty of his was spur-line railroads, those whose lines were
small and off-the-beaten path. “A tough way to make a living,” he re-
called, although he didn’t do badly.
He still vividly remembers one of the very ?rst stocks he ever
bought: Agricultural Research and Development, a “story” stock.
The story: It was developing a technique of breeding pigs immune
to diseases. Torray bought 50 shares at $2. Soon the stock had
soared to $250. Then the truth came out. The company owned a
pig farm in Virginia, and in order to breed disease-free pigs it was
slaughtering all of its pigs that got sick. Not especially scienti?c.
The stock went to zero. Said Torray, “That made a big impression
on me.”
Modern Mistakes
What causes his mistakes these days? “I have a list as long as my
arm,” he said with a sigh. “They’re all over the place. But the main
cause is that the fundamentals of the stock weren’t that good—and I
convinced myself that they were.”
Actually, he’s convinced that mistakes are unavoidable and
there’s no cure. “If this business were easy, it wouldn’t be such
fun—and, of course, all the investment gurus would be retired
multi-millionaires.”
186 ROBERT TORRAY OF THE TORRAY FUNDOne company he bought faced lawsuits because of its use of as-
bestos. Management airily dismissed the whole subject as unimpor-
tant. The issue turned out to be a big problem. Torray sold the stock.
Another mistake he made years ago: He bought into a stock be-
fore he visited with management, something he rarely does. It
turned out that the company was cooking its books—for example,
billing for consignments it had made to Europe that hadn’t been
sold. Not surprising: The company’s of?cers had stock options and
bonuses that depended on the company’s gross income. The chair-
man told Torray it wasn’t his fault—other people at the company
were responsible.
Then there was the $100 million acquisition the same company
had recently made, buying a hearing-aid manufacturer. “Are there
any new developments in hearing aids?” Torray asked innocently.
“Not one,” said the chairman. “The nerve is damaged. What can
you do?”
Torray sold the stock, which soon after lost half its value.
Another time he bought Xerox, thinking that despite its low price
the company had a bright future. Fortunately, it was only a small
part of the portfolio. The stock had dropped from $64 to $20; earn-
ings were projected at $1.90–$2 per share; the 80-cent dividend pro-
vided a hefty 4 percent yield.
ROBERT TORRAY OF THE TORRAY FUND 187
FIGURE 27.1 Torray Fund’s Performance, April 1996–April 2001.
Source: StockCharts.com.Management’s spin was that the deteriorating earnings outlook was the re-
sult of a sales force reorganization, weakness in the Brazilian operation,
and a few other more-minor issues. The real problem, not disclosed then,
was that competition, especially from Hewlett-Packard, was decimating
Xerox’s high-margin copier business. Although the stock rallied from $20
to $30 after we invested, it soon retreated to $20. Then, as more bad news
came out, we sold the stock from $20 down to around $7.
In retrospect, it seems that management was not completely forth-
right about the depth of Xerox’s problems, and may even have em-
ployed accounting gimmicks to mask them. There’s usually no defense
against that.
Compared with Buffett
Like Buffett (and Fisher), Torray buys growing companies, some-
times when they are a bit under a cloud. He concentrates. He rarely
sells. He pays little attention to economic forecasts and ignores the
stock market’s short-term ?uctuations. He’s been light on technol-
ogy: Recently his fund had only 6 percent of its assets in tech, less
than a third of the S&P 500’s 19 percent weighting.
And he boasts a splendid record: up 15.5 percent a year for 28
years, which is double the rise in the S&P 500.
Torray tries to evaluate management before he buys, avoiding peo-
ple who don’t seem shareholder friendly and who focus on short-
term stock performance. How does he differ from Buffett? “He’s got
a lot more money!” replied Torray jovially.
Buffett is also willing to have a more concentrated portfolio. Tor-
ray explains: “Federal securities law and institutional client guide-
lines pretty much dictate that we’re always going to hold at least 25
stocks.” Today his fund has around 35.
Torray also would never buy anything but stocks—not even
bonds. “The attraction of bonds escapes me,” he said disdainfully.
“Their pre-tax after-in?ation return has been only 2 percent annu-
ally over the past 75 years or so. That’s a tough record to like.”
Obviously, both he and Buffett are given to telling what’s on their
minds.
Charming, warm, outgoing, and voluble, Torray, 63, kept calling
me by my ?rst name during the interview, a la the gospel according
to Dale Carnegie; he apologized profusely for brief interruptions; he
never rushed me, even though it was a long interview. Would that all
money managers were so gracious! He’s also wonderfully quotable.
Clear, colorful, interesting, unconventional.
188 ROBERT TORRAY OF THE TORRAY FUNDNot a Value Investor
Morningstar classi?es Torray’s fund as “large, value.” The fund’s
average stock, according to Morningstar, has a price-earnings
ratio of 25.1, only about three-quarters that of the S&P 500, and
historically the fund’s p-e ratio has been only 83 percent of the
S&P 500’s. Its price-book ratio, another measure of value vs.
growth, was recently 4.5, a little more than half the p-b ratio of the
S&P 500.
But as recently as 1997 Torray’s fund was classi?ed as a blend
fund, as it was in 1996 and 1995. And back then it was sometimes a
mid-cap fund. Torray isn’t biased in favor of larger companies. It’s
just that, he explained, larger companies have been so irresistible in
recent years.
Surprisingly, he isn’t happy being called a value manager, and has
some unkind words about value investing in general.
Superior companies, make the best long-term investments. Weak compa-
nies almost always prove disappointing, even if you buy them at a low
price. Some, of course, work out for one reason or another, but in the long
run there won’t be many.
Value investing is generally understood to mean buying stocks at be-
low market price-earnings ratios, higher-than-market dividend yields,
and—to a lesser extent—lower than market price to book value ratios.
Unfortunately, most stocks falling into these categories are issues of
companies having lackluster economic fundamentals. We avoid them.
We’re searching for sound, growing, well-managed businesses that are
fairly priced.
The problem is that the best companies are well known, and as a result
their shares often sell at prices we are unwilling to pay. So we simply wait
until something happens to change that.
In today’s world, regardless of the trigger, we try to assure ourselves as
best we can that the problems will not over time result in a permanent im-
pairment of our investment. We want sustainable growth over decades,
not short-term grati?cation. From our perspective, anything measured in
less than ?ve years is largely meaningless. In the long run, if businesses
perform, their stocks follow suit. If they don’t, no amount of smoke and
mirrors will have the slightest impact.
We’re on the lookout for the stocks of sound companies that have
dropped to a level we’re comfortable with. When we ?nd one, we study
the company reports and talk to Wall Street analysts. If these efforts are
encouraging, we visit management. Then making decisions is easy.
ROBERT TORRAY OF THE TORRAY FUND 189We avoid managements that talk about their stock price instead of the
business. Efforts to light a ?re under poorly performing stocks all too of-
ten end in disaster for shareholders. In this regard, acquisitions have
proven to be a particularly costly strategy. It all comes back to the fact
that value evolves from the business, not the stock.
Solid businesses, even the best, inevitably face challenges, but most of
the time they can be overcome. For weak ones, there is normally no cure.
That’s why it’s so important to buy the best you can afford, at a price you
can live with, and forget about everything else.
Is his strategy, then, “growth at a reasonable price”? GARP? “I just
don’t think about stuff like that,” he replied. “We’re just trying to buy
good businesses.”
The High Expenses People Pay
He warmed to the subject, sounding like no less than John Bogle
(Saint Jack), founder of the Vanguard Group, in his unhappiness
about the expenses that investors must pay to buy and own mu-
tual funds.
Why people ?nd it necessary to attach de?nitions like GARP (growth at a
reasonable price) to the process escapes me. The only answer I come up
with is that in so doing, armies of consultants and brokers, rating services,
and the media position themselves to make a handsome living comparing
one approach to another, record against record, and so on.
This charade is responsible for the wasteful churning of portfolios
and the public’s nonsensical jumping around from one mutual fund to
another.
Last year trading amounted to 40 percent of the assets of more than
4,000 stock funds. I’ve been in business 40 years, and during that time
there has not been an ounce of value added by the crowd that’s been feed-
ing on the relative-performance game.
The Securities and Exchange Commission reports that taxes cost mu-
tual fund shareholders 2.5 percentage points of return annually over the
past 10 years. The industry’s expense ratio absorbed another 1.5 percent-
age points. On top of that, many investors pay 1 percent in fees to ?nancial
advisers to manage portfolios of funds for them. Together, these charges
totaled 5 percentage points.
Corporate earnings grew only about 6 percent annually over the past
50 years. The irony will be lost on no one that investors have been hit
by all three of those costs—taxes, fund expenses, advisers’ fees—have
190 ROBERT TORRAY OF THE TORRAY FUNDtransferred nearly the entire value of their owning stocks, their growth
in earnings, to ?nancial intermediaries and to the Internal Revenue
Service.
Not Going by the Numbers
All mechanistic approaches make no sense, Torray believes. “I buy
companies on a long-term basis. I might buy 8 percent growth at a
p-e of 14, 15, or 16. That might be attractive. At 15 percent growth, it
might be worth a p-e of 22. I don’t analyze things that closely. But I
wouldn’t buy 30 percent growth at twice that. That’s crazy.” (The re-
cent three-year growth rate of the average stock in his portfolio:
12.9 percent.)
Because a 30 percent rate isn’t sustainable? “It won’t last very
long. Certainly not for decades. Look at Lucent now. Technology’s
growth is cyclical, and it’s dif?cult to forecast the cycles. Often in-
vestors own the most at the peak of the cycle, when the prices are
in?ated. It’s hard to identify high p-e, high growth companies for
what we’re attempting to do”—namely, buy long-term winners.
The Secret of His Success
How does he do it? He regularly looks for stocks hitting new lows.
He talks with analysts. He reads. He visits managements. And then
he puts everything together. “Making a decision is easy. It’s like a
sixth sense, an instinct.”
The $1.9 billion Torray Fund has invested in 35 names. The top
?ve recently accounted for about one-third of the portfolio, and
the top ten for more than 50 percent. (Including pension funds and
other institutional accounts, the Torray Companies manage
around $6 billion.) “We normally invest 3 percent–5 percent in
one company,” he said. “Sometimes we’ve ended up with more
than 10 percent in a few cases due to appreciation. But that’s
the limit. Heavier concentrations are ?ne for people dealing with
their own money, but when you’re looking after other people, it’s
inappropriate.”
He buys mostly big companies with long histories. Recently in
his portfolio: Abbott Laboratories, Disney, J.P. Morgan, Gillette,
Bank of America, AT&T, Du Pont, Procter & Gamble, and Kimberly
Clark.
“But at the time we buy them or we’re considering them,” he
ROBERT TORRAY OF THE TORRAY FUND 191explained, “there’s some cloud over their long-term future. In-
vestors are disaffected. We would want to bow out if we think the
negative view has merit, of course. And often it does. But occa-
sionally it’s clear that the problem can be taken care of. It may
take two or three years. The price may go even lower while we’re
waiting.
“Other times, we don’t believe the popular view—and to our re-
gret. We wind up taking a loss. But that hasn’t happened very of-
ten. And when it has, adequate diversi?cation has muted the
impact.”
One of his stocks, Abbott Labs, for example, sank in 1999 when
there was bad news about expiring drug patents and a Food and
Drug Administration investigation. In 2000 the stock shot up more
than 50 percent.
Patience Is a Virtue
When Torray talks with his friends in the investment world about the
long-term outlook for companies he buys into, many of them agree.
The stock’s a bargain, its long-term prospects are rosy. But the tim-
ing is wrong. They can’t wait eighteen months, two years, or three
years.
“Many mutual fund managers are under the gun,” he said, a view
that Edwin Walczak of Vontobel U.S. Value (Chapter 28) would
wholeheartedly endorse. “Shareholders will vote with their feet,
and the manager will soon be out of business. It’s hard for an insti-
tutional investor to be long-term oriented. Problems can be
painfully slow to work out. And the way the investment world
works, few money managers can afford the luxury of waiting two or
three years.”
He himself has held onto stocks for as long as three or four years
before they proved their mettle.
The portfolio management business is intensely competitive, and in-
vestors tend to take ?ight if they’re not keeping pace with the market’s
best-performing stocks or the hottest mutual funds. This tends to keep in-
vestment managers constantly in motion trying to land in just the right
place at the right time. Generally, that translates into buying stocks with
the greatest upward price momentum, no matter what their fundamentals
or valuation levels happen to be.
In that sort of game, the three- to ?ve-year outlook for Abbott Labora-
tories, Johnson & Johnson, Gillette, or Procter & Gamble is irrelevant.
192 ROBERT TORRAY OF THE TORRAY FUNDAs a result their shares may stagnate or fall temporarily, making them at-
tractive to investors like us. These companies and others we own are
big, safe, and generally well managed. As a group, their overall economic
position is superior to that of the combined companies in the various
market indexes. So we assume that if we hold them long term, we will
do better than the market—which we have. It’s really as simple as that.
Something else he thinks is important: “We are focused on making
money and avoiding the risk of permanent loss—not focused on
beating the market and beating other funds. We really don’t care
what others are doing or how they’re doing it. We’re looking out for
our investors, which includes ourselves.”
Did his own fund investors drop out in the year 2000, when his
fund was down? “Actually, last year was a standoff in this regard,” he
replied. “I’m comfortable with the outcome. Our fund was down 3.4
percent, which we’re not happy about, but it had returned 29 percent
annually during the preceding ?ve years. A slowdown was in-
evitable. The S&P 500 was off 10 percent, and the Nasdaq collapsed
nearly 40 percent. We weren’t swimming against the tide. That hap-
pens every three, ?ve, eight, or nine years. Prices were ahead of fun-
damental values. And when that happens, even good stocks are
highly unlikely to go up.”
When to Sell
While Torray is disinclined ever to sell, his turnover rate is never
zero. Usually it’s between 20 percent and 30 percent. In 2000, in
fact, it was unusually high—33 percent. “I made three or four mis-
takes,” he admitted. Another reason he sells: when a new opportu-
nity presents itself. “We’ve got to sell an old holding to buy a new
one.”
Does he bail out if a stock seems overpriced? “Some I’ll hold
onto. The big problem is, I may be wrong. The stock may not be
overpriced. And if I sell it, I’ll have to buy something else just as
good—and that’s not easy to do. Besides, value doesn’t lie in the
stock’s price. It’s in the business. That’s something I learned from
Buffett. Like him, I’m mainly interested in the business, not in the
stock.
“Most investors just ‘play’ the market. Investors see a penny or a
two drop in earnings, and there’s a 20 percent decline in the stock. I
pay no attention to short-term earnings. I just want to make sure that
the growing power is still there.”
ROBERT TORRAY OF THE TORRAY FUND 193Questions and Answers
Q. When you visit companies, what do you want to see in manage-
ment?
R.T. Forthrightness. A focus on long-term developments.
I’m put off if they’re stock conscious. If they talk about mergers and
acquisitions, that’s usually only a short-term bene?t. I want them to
focus on the business and forget the stock.
Also, sometimes management will say things that don’t support our
view of the business and where it’s headed.
Q. Will you close your fund if it gets large enough?
R.T. With new money, you can buy new stocks. You can bolster some
older stocks and adjust your portfolio weightings. Cash ?owing out
is terrible: You may have to sell stocks when you want to buy more.
Q. Why is it that some money managers with superb records are
here one day, gone the next? Or that they seem to lose their golden
touch?
R.T. You need to be independent and pretty well established for
your investors to stay with you. People don’t know what will pan
out, so it helps to have a good long-term record. Our average client
has been with us for 19 years—out of 28. And the institutions that
hire us tend to have multiple money managers, 10 or maybe even
30. They’ll never ?re us—unless we were so bad that we stuck out.
Besides, we have a sensible philosophy and we can explain it.
That gives people comfort. If you can’t explain your strategy, and
people can’t read about you, you’ll lose your investors and wind
up working for Fidelity. [In other words, not running your own
business.]
In general two classes of money managers have gotten into trou-
ble of late.
•Hedge funds, like Long Term Capital Management. “Some of
them have had stunning returns, but they had made large-scale
investments, such as on the direction of interest rates and with
enormous leverage. Sometimes they were right. But when they
made investments that lost money, their bets couldn’t be un-
wound.” There were no buyers.
•Value investors, who “have been crushed in the last few years. We
made 29 percent a year for the last ?ve years, and I don’t know a
value investor who’s done that. They were buying Old Economy
194 ROBERT TORRAY OF THE TORRAY FUNDcompanies, Caterpillar Tractor, General Motors, the old Interna-
tional Paper. They all own the same stuff. Even I bought some.
They used to go in during a down cycle and sell during an up cy-
cle. In recent years, these stocks went from 54 to 15 or from 60 to
20 as everyone left and went into high tech and dot.coms.
Q. But Morningstar reports that Torray owns a ton of General Mo-
tors. How come?
R.T. [Annoyed] I’ve told them ten times that we don’t own any
General Motors and we never have. They still say we do. We own
General Motors Hughes Electronics, a spin-off of General Motors,
not General Motors. It’s one of our best holdings. As for General
Motors, one thing you can say about it is that for 40 years it’s been
the same price. Fifty dollars. Or around $50. That’s all you need to
know about General Motors.
Torray is skeptical of the Old Economy, of old industrial stocks in
general, maintaining that their free cash ?ow has been drying up for
the past 10 or 15 years. Every last cent they make now goes into new
plants, research, and development, he claims. Just to pay their divi-
dends, they must now issue new bonds.
Unconventional Opinions
Some of his other unconventional opinions sound distinctly reminis-
cent of that gentleman from Omaha:
•“Ignore what academia has to say, and ignore market strate-
gists. Keep it simple. Buy and hold good companies and you’ll
be a winner.”
•“Conventional thinking produces conventional results. And
we’re not interested in conventional results.”
•“I’ve never known anyone whose fortunes were improved
through diversi?cation. [He modi?ed that to:] Diversi?cation is
important up to a point, but too many investors overdo it.”
•“Owning a half-dozen or more mutual funds makes absolutely no
sense. The average fund holds nearly 150 stocks, so a multiple-
fund portfolio could easily own 1,000. Stock turnover within funds
runs nearly 100 percent a year, and advisers often switch funds in
their clients’ accounts. There is no chance that this hyperactivity
will add value. In fact, the embedded costs and futile randomness
of the process virtually guarantee investors a lousy result.”
QUESTIONS AND ANSWERS 195•“Asset allocation is total nonsense. All it does is keep a lot of
people employed. The only thing worth owning is stock in grow-
ing companies. Never buy bonds, commodities, futures, deriva-
tives, strips, and all that other nonsense.”
•“Brokerage ?rms don’t want salespeople who think too much,
even if they think about the companies they recommend. They
just want gregarious people who’ll go out and sell.”
His record speaks for itself, he said proudly. Up 15.5 percent a
year for 28 years. Over ?ve years, up more than 17 percent. Since the
fund’s inception, up more than 18 percent.
Even so, he added, he has regularly made mistakes—and he still
does. “After 40 years in the business, it’s still not too late to learn.”
196 ROBERT TORRAY OF THE TORRAY FUND
Basics
Minimum First Investment: $10,000 (same for an IRA)
Phone Number: (800) 443-3036
Web Address: www.torray.comCHAPTER 28
Edwin D. Walczak of
Vontobel U.S. Value
E
dwin D. Walczak was engaged in a session of intense self-scrutiny
when I dropped in at his of?ce on Park Avenue in New York City
not long ago. Sometimes, he even seemed to contradict himself, as in
dealing with the question of: Is exhaustive research the secret of in-
vesting?
After 10 years of managing Vontobel U.S. Value, he’s beaten the
S&P 500 by a hair—but fairly soundly if you don’t include ex-
penses. But why, he has been asking himself, hasn’t he risen to the
top? “They’re not the kickass returns I would have liked. How do I
do better?”
His numbers: 1.8 percent over the S&P 500 after 10 years, 2.25 per-
cent over without expenses. Morningstar rates the fund “average”
now, but usually it’s rated “above average.”
197
Edwin D. Walczak (Photo courtesy of
Vontobel Funds).Walczak is open, articulate, engaging, wired.
In his company’s conference room—a painting of Vontobel him-
self, the family founder, gazes down on us—Walczak, blue shirt, no
tie, asks himself:
•Should he concentrate more? Buy 10 stocks he knows very well
instead of 25 he can’t know quite so well?
•Should he hold on and on, instead of trimming positions when
stocks begin approaching and reaching their supposed intrinsic
values?
•Is it just that value investing was so out of favor in recent years,
and in more normal times he and other value investors will do
far better? Before the tech bubble, he was 3 percent ahead of
the S&P. “Don’t change, they tell us,” he says. “And I don’t want
to panic. But how do I do better?”
•Why haven’t he and other Buffett Moonies, as he calls them,
done as well as the Master himself? “Why have we trailed
behind?”
It isn’t that he’s dumb. “If I were three times smarter, a great intel-
lect,” he said candidly, “it wouldn’t solve the problem. There’s only
so much you can know. I’m no Einstein, I’m just a regular guy. But
twice the brains wouldn’t solve the problem.”
His ego is not easily wounded, either; he can admit mistakes and
analyze them. With a rueful smile he recalled that a former em-
ployer used to ask him, “What’s on your alleged mind, Walczak?”
And he told of visiting Mario Gabelli (a fellow graduate of Colum-
bia Business School) to ask for a job in 1983 or 1984. He made an
impassioned case for stocks like Chrysler and Ford. Gabelli lis-
tened, then told him bluntly, “If you want to work here, you’ll have
to pay me.”
Walczak now knows that Gabelli was right about those dismal
companies: “I didn’t know shit.” But he hopes that if he applied for a
job today and talked up Markel Insurance, Mario might not “laugh
me out of the room. Gabelli really knows his stories.”
Maybe he’s too conservative, Walczak grants. His own answer is a
gardening metaphor: When you plant shrubs, you’ve got to get down
deep, to your elbows. You must do more in-depth research. ... But
he already does a ton of research, he reminded himself. And
“There’s only so much you can know about Coke and Hewlett-
Packard.”
198 EDWIN D. WALCZAK OF VONTOBEL U.S. VALUEWhat about calling the CFOs more often? “Nnyah,” he answers,
making a face.
A quandary.
The Lower Depths
His mantra, Walczak revealed, is: “There is hardly anything that I
know, and there is hardly anything that I can or should do.” Modesty
to the point of self-loathing, but that outlook should keep his
turnover pretty low and his portfolio concentrated.
The nonvalue years were a nightmarish time. Walczak thought he
might even get ?red. Robert Sanborn at Oakmark did. Other value in-
vestors, like Denis LaPlaige at MainStay and David Schafer at Strong
Schafer Value, formidable and admirable people, mysteriously disap-
peared. At one point, Vontobel U.S. Value had $600 million in assets.
Assets plunged to $125 million.
So despondent was Walczak back in 1999 that he went to the Berk-
shire Hathaway annual meeting, hoping to get inspiration from the
Master himself, like a priest assailed by self-doubts visiting the Vati-
can to see the pope.
He talked about “the imperfections of the business.” You can’t
be an investor and a money manager at the same time. A money
manager is at the mercy of his customers; and the average cus-
tomer is a momentum investor and ?ckleness and emotionalism
run in his or her veins. The average investor holds a tech stock for
40 days. So either run a closed-end fund, Walczak thinks, or just
manage your own money, so you can forget about the sweet sim-
plemindness of Irving and Irma Investor. “They’re in at the highs
and out at the lows.”
Questions and Answers
Q. Well, what about your institutional clients—the pension funds,
for example?
E.W. Institutional clients don’t want their money managers to devi-
ate much from their index, from the S&P 500. So you’re hemmed
in. And even they are apt to leave when the weather turns chilly.
We have no long-term clients. Now, if the markets calm down and
we had the right kind of investor....
QUESTIONS AND ANSWERS 199I’ve been here 12 years, and I’ve been reasonably free—freer than
most. I can even be nondiversi?ed [run a fund with concentrated in-
dustry weightings and relatively few stocks].
But there’s no liferaft when value stocks fall into the pit and
growth stocks climb to the skies. If you sell straw hats, there’s no
salvation when the snow?akes start to fall.
A few famous value funds didn’t suffer so much, like Tweedy,
Browne and Sequoia. “I’m envious. They’ve been around longer,
and they’re bigger,” Walczak said. “We’re small, and we have no
distributors. In 1998, a good year for us, money was out the door.
I’m lucky to have stayed in the business.” In 1998, his fund rose
14.71 percent; in 1999, down 14.07 percent. The year 2000, though,
was super: up 35.18 versus the S&P 500, down 10 percent. (See
Figure 28.1.)
Even without momentum investors ready to skip without a mo-
ment’s notice, running a value fund would be no picnic. Today, there
are hardly any good companies out there that you can scoop up for a
song. “It’s a limited universe,” Walczak said grumpily. “The potential
is very, very narrow. There may be 150 companies good enough for us
to buy. There used to be only 50 or 60, but now I’ll even consider Intel
and Microsoft and Ford—though I haven’t pulled the trigger on any of
them yet. Not even at their lows. They’re not predictable enough.”
200 EDWIN D. WALCZAK OF VONTOBEL U.S. VALUE
FIGURE 28.1 Vontobel U.S. Value Fund’s Performance, 1994–2001.
Source: StockCharts.com.Supposedly all you have to do is choose a company that will pros-
per over the next 10 or 20 years, isn’t that right? “It’s hard to ?nd
great companies,” he answered. “It’s hard to make good forecast for
even three years. Hardly any company continues to grow at 15 per-
cent a year for ten years. There’s competition, there’s screwups.”
Gillette, Rubbermaid. “In tech, who will be the winners in three
years? These companies have too many moving parts.” In this busi-
ness, “Certainty is very hard to come by. I’m kidding myself if I’m
sure that a great franchise will still be a great franchise ?ve years
from now.”
Other value investors have suffered blue periods, too. Richard
H. Jenrette, former CEO of Equitable, noted in his book The Con-
trarian Manager (New York: McGraw-Hill, 1997) that “I’m not
sure that the contrarian approach to investing is any longer applic-
able to the management of today’s institutional capital. ... The
pressures for short-term investment performance are so great that
a contrarian approach, which means going against the herd,
becomes very risky to the personal well-being of the portfolio
manager.”
More Questions and Answers
Q. Have you ever thought of becoming a growth investor?
E.W. I’m chicken. I’m afraid of losing money. When a stock gets to
be fairly valued, I’m nervous. I tend to trim. A discipline has to
work, and it has to suit your personality. I like value investing, it
makes sense, and it suits my used-Toyota personality.
All growth companies can be value buys—at the right price.
You’re trying to buy Michael Jordan for the price of a minor league
ballplayer. You don’t want to buy no-growth junk. We’re not deep
value. We don’t want Chrysler or Ford. We want Interpublic, AIG,
Automatic Data Processing—at our prices. We want a company
that delivers the goods. It’s not that complicated.
Q. How do you calculate a company’s intrinsic value?
E.W. You need a strong stomach and a strict discipline. Analytical
success accounts for only 25 percent. You had to buy banks in
1990, pharmaceuticals in 1993, growth stocks in 1997, and insur-
ance companies and ?nance last year. You need enough con?-
dence and enough knowledge—and you never get enough.
Whoever knows the most wins.
MORE QUESTIONS AND ANSWERS 201Q. Aren’t there any magic formulas?
E.W. There’s no magical way to arrive at intrinsic value. Dis-
counted cash ?ow. Garbage in, garbage out. The real question is,
does the company have a sustainable competitive advantage?
Hardly any do. ADP is on my list. But I’ve never owned it. Wal-
green would be perfect. I’ve never owned it. What companies will
do in ?ve or ten or ?fteen years isn’t knowable. You’ve just got to
mindlessly extrapolate.
Q. What about all the arithmetic?
E.W. That formula stuff isn’t predictive.
If it were, you know what Buffett said: Librarians would be bil-
lionaires. It’s not that inanely simple. Something is going on be-
yond those inane wooden numbers, beyond a decent return on
equity. Math is 10 or 15 percent, and qualitative is 90 percent. What
does a company do, how does it work, and does it have too many
moving parts? You’ve just got to get your hands dirty.
I was never that good at math. I need help in ?guring out tips to
pay in restaurants. There are just three or four variables you have
to know, as Marty Whitman has said. It’s an evaluative process.
You’ve got to study the pros and the cons.
Walczak doesn’t rely much on analysts. He ?nds that reading ?ve
newspapers in the morning, along with ?nancial magazines, is as
good if not better than analysts’ reports. He singles out Sanford
Bernstein, a former employer, for praise, though. And he talks to an-
alysts on the “buy” side—those who don’t work for brokerage ?rms
but for, say, mutual funds.
He mentioned that Charlie Munger said that he hadn’t seen Buffett
doing a whole lot of math. Buffett’s response: He doesn’t have to. A
stupendous bargain isn’t hard to spot. You don’t have to measure
Mount Everest to recognize that it’s one big pile of rock.
Q. Why shouldn’t the ordinary investor just buy Berkshire Hath-
away B shares? Why a fund like Vontobel?
E.W. We’re more ?exible, more agile. We’re not buying whales,
we’re buying minnows. We’re so small, we can have a larger array
of ideas.
Not that he isn’t a great admirer of the Sage of Omaha. When he
went to the Berkshire annual meeting, he drove by Buffett’s house. “I
like where he lives,” he said. “A modest house in Omaha instead of in
the Hamptons. And I like his intellectual honesty.”
202 EDWIN D. WALCZAK OF VONTOBEL U.S. VALUEMORE QUESTIONS AND ANSWERS 203
Basics
Minimum First Investment: $1,000 (there’s a 2 percent redemption fee)
Phone: (800) 527-9500
Web address: www.vusa.com.CHAPTER 29
James Gipson of
the Clipper Fund
O
n the tenth anniversary of the Clipper Fund, in 1994, I asked James
H. Gipson, the manager, why his fund—unlike so many other con-
trarian funds—had been so successful.
“We do a more diligent job of analyzing companies,” he answered.
“Also, other people say they’re contrarians but they don’t invest that
way.” This was before the ascension of Bill Miller, the Legg Mason
money manager (Legg Mason Value Trust) who committed heresy by
purchasing a variety of Internet stocks.
Questions and Answers
Q. Do you look for a catalyst that will revive a stock that’s out of
favor?
J.G. In some cases, you can ?nd a catalyst. But that’s too clever
by half. Most of the time we don’t try to be that clever. One of the
hardest things to do is to know what stock will go up and when.
You never know. Still, 75 percent to 80 percent of our stocks
work out.
205Q. What else do you do differently?
J.G. We concentrate to a greater degree. We have only 30-odd
stocks. That’s very unusual. If you’re intellectually honest, you
know that your top 10 best ideas will do better than your 40 to 50
best ideas. If you have the courage of your convictions, you feel
that your best ideas will do best.
Gibson, Michael Sandler, and Bruce Veace, the managers of Clip-
per, were named Morningstar’s stock fund managers of the year for
2000. As Morningstar noted, by sticking with seemingly cheap
stocks, and retreating to bonds and cash when stocks just didn’t
look attractive, the fund trailed the Standard & Poor’s 500 for four
consecutive years. The year 1999 was the worst: As investors sought
big tech stocks, the S&P 500, dominated by such stocks, rose 20 per-
cent; Clipper fell by 2 percent. The year 2000 saw the righteous re-
warded: Clipper rose 35 percent, the S&P 500 went down 10 percent.
(See Figure 29.1.)
The three men look for stocks with powerful franchises, stocks
that are selling for 30 percent less than their intrinsic value. Its
stocks aren’t “supersexy,” said Sandler, “but they have fundamen-
tally strong businesses and throw off a lot of excess cash.” Among
Clipper’s big winners in 2000: Philip Morris, Freddie Mac, Fannie
Mae. Sandler calls Philip Morris “a cash machine,” apparently not be-
ing frightened away by its legal woes.
206 JAMES GIPSON OF THE CLIPPER FUND
FIGURE 29.1 Clipper Fund’s Performance, 1994–2001.
Source: StockCharts.comA far more volatile version of Clipper is UAM Clipper Focus,
without the cash or the bonds. Recently it had 35 stocks, but the
top ?ve made up 36.5 percent of the portfolio. It has not only more
stocks than Clipper; it has two more managers: Douglas Grey and
Peter Quinn. The minimum is $2,500. Phone: 877-826-5465. Web
address: UAM.com. You can buy this fund through Waterhouse
and Schwab.
Clipper is an unusually stable fund, with a beta of only 0.37. Its
correlation with the S&P 500 is only 25 percent. But its turnover
was surprisingly high for this kind of fund: 63 percent in 1999, 65
percent in 1998. Recently it held 31 stocks and was 28 percent in
cash. Morningstar rated the fund “highest” both vis-a-vis other
stock funds and vis-a-vis other large-value funds. With some exag-
geration, Morningstar called Clipper “a good choice if you can hang
on for 15 years.”
QUESTIONS AND ANSWERS 207
Basics
Minimum First Investment: $2,500 (IRAs: $1,000)
Phone: 800-776-5033
Web Address: clipperfund.com.CHAPTER 30
Michael Price of the
Mutual Series Fund
I
n 1999 the Mutual Series family of funds held a press conference at
the Yale Club in New York to mark the family’s 50th anniversary.
The very ?rst fund in the family, Mutual Shares, was founded in 1949
by the late Max Heine and by Joseph Galdi.
I suspect that the conference was also held to point out that—de-
spite the decision of the former manager, Michael Price, to play a
lesser role—the funds haven’t fallen off a cliff.
Many investors (including me) left when Price stepped down after
he sold Mutual Series to the Franklin family, which levels sales
charges. Franklin Mutual Series’ assets shrank from $32 billion to
$22 billion.
The conference was top notch. All the Franklin Mutual managers
who spoke were interesting and shrewd—and funny.
209
Michael Price (Photo courtesy Mutual Series
Fund).Robert L. Friedman, then chief investment of?cer, recalled that
Max Heine had said that if you were a true value investor, over a
decade you would enjoy one fantastic year, suffer one horrible year,
and have eight good years. The challenge, according to Heine, is to
stick with value stocks even during the horrible year.
Heine, a lawyer who emigrated from Nazi Germany in 1933, “had a
?air for bargain-hunting,” Friedman said. He used a three-pronged
investment approach that the fund family still employs, Friedman
went on, buying:
•Undervalued common stocks
•Risk arbitrages (buying the acquired companies before mergers
and selling the acquirer)
•Bankruptcies and distressed companies
What put the Mutual Series funds on the map, Friedman went on,
was Heine’s buying Penn Central bonds for 10 cents on the dollar af-
ter the railroad went bankrupt in 1976. “He ?gured that even if they
just melted down all the track, they could repay the debt.” That
episode underscored the family’s edge: “courage in the face of panic;
patience; and hard-core research.”
Price, who succeeded Heine, began putting pressure on compa-
nies to work to raise their stocks’ prices, Friedman said. Today, he
added, all of the family’s senior people are ready to urge top manage-
ments of companies the funds have invested in to make their compa-
nies more ef?cient.
The fund managers have three choices: (1) to sell the stock, (2) to
say something privately, and (3) to say something publicly. If No. 2
doesn’t work, Friedman explained, they will try numbers 1 or 3.
Another speaker, Larry Sondike, then co-manager of Mutual
Shares, said that the under-a-cloud stocks that the fund buys may
have been in deals that fell through, in litigation, or “in pain.” We
don’t mind pain, Sondike commented, “as long as it’s not ours.”
David Marcus, co-manager of Mutual Discovery, said that he trav-
els abroad again and again to talk with a company’s executives. (Dis-
covery invests heavily abroad.) Even in Europe, the family’s habit of
buying unloved stocks startles people.
When Marcus was buying 3 percent of a French water company
called Suez, “a French stockbroker told me that I was stupid.” The
stock tripled in a little more than three years. Suez of?cers were
grateful that Discovery had buoyed up their stock, so when they
210 MICHAEL PRICE OF THE MUTUAL SERIES FUNDcame to this country later on, they hurried to New Jersey (the family
is in Short Hills) to meet with their benefactors.
Traveling abroad really helps, Marcus went on, because you can
learn what the truth really is. When foreign executives come to New
York to meet with money managers, he said, “they talk about re-
structuring, about shareholder value, about buy-backs.” They tell the
analysts what the analysts want to hear.
“But it’s just puffery,” Marcus said contemptuously. “You can see it
in their faces.”
David Winters, the funds’ young (39) and new chief investment of?-
cer, is an unabashed admirer of Warren Buffett and attends Berk-
shire’s annual meetings.
The secret of Michael Price’s strategy, I suggested to Winters, is
something Price once said to me: “We really kick the tires.” He and
his analysts go in and ?nd out what a company’s book value really is.
Yes, he agreed, that’s what he learned working for Price. “Do the
work.” That’s what Mutual Series is all about: hard work.
Is he also an admirer of Ben Graham? “Graham wrote the Bible,”
he answered. “Buffett, Heine, Price, Carret, and all the others are
commentators.”
When he interviews job candidates, Winters said, one of the ?rst
questions he asks is: “Have you read Ben Graham?” Depending on
the answer, “You’re either in or out. On the train or off.”
Highlights of an interview with Price before he stepped down from
the Franklin Mutual Series funds:
•No, he’s not burned out. “I come to the of?ce every day. I still
get up every day and read the newspaper. I care about this place, and
I’ll always pay it a lot of attention. And I’ll always be a money man-
ager. I’ll always be interested in the market. But I’m not going to start
a hedge fund.” (A hedge fund, an adventuresome investment for very
wealth investors, would probably make him more money.)
•If anyone wants to purchase a ?rst Mutual Series fund, a good
choice would be Mutual Beacon, Price suggests. It’s 25 percent in-
vested in Europe, the rest U.S., and it’s conservative. “One fund gets
you a good mix.” (See Figure 30.1.)
•On the stockbrokers who now sell his funds, which used to be
no-loads: “They’ll keep you out of trouble. They’ll steer you to the
right funds.”
MICHAEL PRICE OF THE MUTUAL SERIES FUND 211I had asked for an interview after seeing part of a PBS documen-
tary about problems in the American economy, “Surviving the Bot-
tom Line with Hedrick Smith.”
Price “had a feeling” that the interviews on the program would be
a “hatchet job,” but “I thought it would be more balanced.”
The program ends with Smith proclaiming that while people have
been tragically losing their jobs “the winners ride off with their
gains.”
Then you see Michael Price, a polo player, riding off on a horse.
Welcome to tabloid television.
I had told Price’s secretary, Irene Christa, that the program had
been a hatchet job. She replied that others had told them the same
thing.
Price and a few others are portrayed as nineteenth-century black-
guards, guilty of forcing companies to lay off their loyal employees,
meanwhile themselves becoming disgustingly rich. There’s a lot of
?lm of Price atop a horse and playing polo—polo, of course, being a
sport for the rich and decadent.
Later on, Smith, a South African journalist, follows Price as he
meets with some people in an of?ce. The camera lingers on the label
in Price’s jacket: “Made for Michael F. Price.”
212 MICHAEL PRICE OF THE MUTUAL SERIES FUND
FIGURE 30.1 Mutual Beacon Fund’s Performance, 1994–2001.
Source: StockCharts.comOn the program, Price’s sin is that, as Chase Manhattan Bank’s
biggest shareholder, he pressured Chase to raise its share price.
Eventually Chase agreed to merge with Chemical Bank, and—there
being a lot of duplication—closed of?ces, throwing 12,000 people
out of work.
Chase of?cers are quoted as saying that they had been trying to fo-
cus on the long term, but they were forced to make short-term deci-
sions thanks to pressure from Price and other shareholders. So they
laid off workers—the ?rst layoffs in Chase’s history.
The heroes of the program are, ?rst, the executives at Chase Bank.
Now, I happen to know that these guys wouldn’t dream of playing so
priggish a game as polo. Heck, come a Friday night you can ?nd
Chase guys bowling and happily swilling beer at Nick’s Bowl-a-Rama
on Eighth Avenue, just like you and me. Sometimes, you’ll even
catch them hanging out at the roller derby, recalling old times with
old Tuffy Brasoon herself, who would be in the Roller Derby Hall of
Fame (if there were one).
Custom-made clothes? Forget it. Chase guys always buy stuff off
the rack at Filene’s Basement.
I told Price about a shamefully forgotten Chase executive named
Al Wiggin. While chairman of the Chase National Bank (a predeces-
sor of Chase Manhattan), he sold short 42,506 shares of Chase in
1929, borrowing money from Chase to do so. (When you sell stock
short, you bet on the price going down.) Al did it sneakily, in the
name of his daughters. In no time at all, he romped away with
$4,008,538.
Selling a stock short helps drive down the price—not exactly what
Chase, in the year 1929, was paying Wiggin $275,000 a year for.
By the way, I know that Wiggin lived on Park Avenue and sum-
mered at his place in Greenwich, Connecticut, and that he belonged
to the Metropolitan Club, the New York Yacht, The Links, and other
exclusive clubs, but I have not been able to ascertain whether he
was guilty of playing polo. Still, if you’re really looking for true vil-
lains, Al is your man.
Price seemed, understandably, a little ticked off by the TV pro-
gram. He began by talking about polo. He plays because he likes
riding horses and he loves team sports. “My knees are shot, so I
can’t play other team sports. [He had played football in high
school.] Polo is hard work. It’s not glamorous. If you don’t ride, you
won’t understand.”
Besides, polo isn’t that expensive. “I spend less, as a percentage of
MICHAEL PRICE OF THE MUTUAL SERIES FUND 213my income, on polo than the average American pays to buy reels and
lines at Wal-Mart for bass ?shing.”
In any case, the money he uses to play polo he earned “making
money for 25 years for the average American. We’ve provided terri?c
risk-adjusted returns, and at Wal-Mart prices.” The Mutual Series
funds do have superb records, though most new buyers must now
pay sales charges.
As for his custom-made suits, he apologized: He weight-lifts, so his
arms and shoulders are too big to ?t into ordinary suits.
Obviously, he was being too defensive. If I myself were really well-
to-do, I’d wear custom-made suits, too. Why try to become rich if
you’re not supposed to enjoy spending money? Should Bill Gates live
in a one-room ?at, drive an old jalopy, and dine at Wendy’s? You ex-
pect me to be ashamed that I blew several thousand dollars visiting
Italy last year?
In any case, Price wasn’t born with a silver spoon in his mouth.
When he graduated from the University of Oklahoma, “I had no
money. Zilch.” And, last I looked, the U. of O. wasn’t in the Ivy
League. The PBS program didn’t mention that Price just gave $18
million to his alma mater.
On Chase Bank: The Mutual Series funds, Price said, have in-
vested a lot of money to help banks and other institutions stay in
business. “In just 1991 through 1993, we saved seven banks from go-
ing under.” Other ?rms that the fund bailed out include Penn Central
and “a lot of companies no one heard of.”
The consolidation of banks was inevitable because there were
too many, Price went on. “They’ve gone from 12,000 nationwide
a few years ago to 5,000 now, on their way down to 2,000
eventually.”
The TV program itself, Price pointed out, was sponsored by the Al-
fred P. Sloan Foundation, Sloan having been an executive at General
Motors. Price couldn’t sleep the other night, and began watching the
?lm Roger and Me on TV, about the former bumbling chairman of
GM, Roger Smith, and his refusal to confront the havoc GM caused
in towns where it closed factories.
The Mutual Series funds began buying Chase at $33. “We thought
it was worth $65.” Company of?cers, he learned, had been promised
a huge cash bonus if the price rose to $55 in two years.
“We told them that we had a plan, that Chase could sell this off
and spin this out. Why don’t they do it tomorrow? We felt a sense of
urgency.”
214 MICHAEL PRICE OF THE MUTUAL SERIES FUNDIf Chase hadn’t merged with Chemical, Price argued, Chase would
have turned into a very “sick” company, and many more people
would have been laid off.
“Companies need to be loyal to their workers,” Price went on.
“They owe allegiance to their employees. I believe that.” But
Chase wasn’t doing well. “It was the worst bank in its peer group.
It had the lowest return on equity. And shareholders call the
shots.”
I told Price, somewhat facetiously, that if he had not done his best
to raise Chase’s price, I—as a shareholder of Mutual Discovery—
would have sued him. “What have I been paying you for?”
“You wouldn’t have sued me,” he said pleasantly, but yes, his job is
to buy cheap stocks and help push up their prices.
At the end of my interview I apologized to Price for the schlocki-
ness of some my fellow journalists—and thanked him for enabling
me (and a lot of other middle-class Americans) to live comfortably
and to retire comfortably.
A few years ago, the Mutual Series funds held a shareholder
meeting at the Madison Hotel in Madison, and a crowd of ordinary
people, most of them elderly, showed up. They showered Michael
Price with affection—for having made them good money, year
after year. Some even presented him with little gifts. It was a
love-fest.
From another interview, while Price was managing the funds:
Questions and Answers
Q. Would you describe your strategy?
M.P. Well, we are kind of a long-term investment company. We’re
categorized as a growth and income fund, which we are. But we
really are a special situation fund and a long-term investor. We are
bottoms-up investors; we buy companies because of speci?c rea-
sons. We don’t buy stocks because of feelings about the market, or
interest rates, or the election, or in?ation; we only buy assets at a
discount.
We couple that with two other things: bankruptcy investing,
which is just a cheaper or more interesting way to buy assets at a
discount, and trading stocks of companies involved in mergers,
tender offers, liquidations, spinoffs. We do those things to get
rates of return on our cash.
QUESTIONS AND ANSWERS 215That’s it; that’s all. Those are components of the portfolio. We
don’t have a strategy—it’s the wrong word; we have a kind of
philosophy of buying assets at a discount, and our approach is
by those three things: Graham and Dodd [value] investing, bank-
ruptcies, and deals. That’s all we do. We don’t really look at
other groups.
If the market doesn’t reward the value investor, and it didn’t in
1990 and 1991, we don’t change what we’re doing—because we
believe in what we’re doing.
Q. What do you do differently from other value investors?
M.P. I don’t know, it’s how you do the work, having an attitude that
you’ve got to do your own work. You can’t just take what others
tell you a company or an asset is worth. You have to get several in-
puts to value assets. You’ve got to be somewhat disciplined to
make sure you wait until the market hands you the stock at a
cheap price—it’s very hard to do. In other words, do good work on
the valuation side and then wait for the market to give it to you
cheaply.
I think we do very good work on the valuation and on the mar-
ket side, but sometimes we pay too much on the market, and
sometimes we buy things at the right price. We stick to this philos-
ophy. It’s great if you can do the homework and then wait for the
market to give you things at a big discount from what they’re
worth. That’s the best philosophy, you know; you don’t have to pay
attention to technical analysis, or the gibberish on Wall Street, or
new product conventions.
Wall Street basically doesn’t eat its own cooking. In the last ?ve
or 10 years—I don’t know how long you’ve been watching Wall
Street—but you’ve had the invention of zero coupon bonds, PIKs,
options, futures. They really take what is a very simple mecha-
nism, which is capital formation and capital investment, and make
it much more complex than it needs to be, because Wall Street can
earn big fees in commissions on the issuance and trading of these
instruments. But all those things create a lot of noise, a lot of dis-
tractions, from what is a very simple business for an investor,
which is to buy a stock based on what the business is worth at half
of that price.
If they’re not there, you don’t buy them; if they’re there, you buy
them and you wait—because sooner or later they’re going to trade
for what they’re worth. All this nonsense Wall Street creates—
junk bonds, PIKs, zeroes, futures and options, or all the different
strategies, all the things you read about in the [Wall Street] Jour-
216 MICHAEL PRICE OF THE MUTUAL SERIES FUNDnal—they tend to pull investors’ attention away from the funda-
mental things you should pay attention to.
What we try to do at Mutual Shares is view the world simply;
don’t get distracted by all of the stuff Wall Street cooks up. Stick
to the simple stuff. Buy oil at below $5 a barrel, and gas for 50
cents, and a dollar for 50 cents. You buy liquid assets as cheap as
you can ... because then you can’t lose much money.
We are not stock players, and we’re not trying to guess future
earnings. We don’t come in the morning and say, “Oh, the market
is high, let’s buy some S&P puts.” We just would never do those
things.
Q. What qualities unite successful investors?
M.P. There are lots of successful investors who do things other
than what we do. I’m saying this is our philosophy. I think there
are several very successful people who kind of take this view,
who have been around a long time. People in Sequoia are won-
derful and have a very simple direct approach. John Templeton
is still great; he still has very long-term views on how to buy
stocks.
So we are active in situations to create cheap securities because
we have the energy and the knowledge to know how to do the
work, to ?gure out a bankruptcy, to create a cheap stock. But at
the end of the day, we want the cheap stock; we’re not trading in
the bankruptcy just to trade. We don’t do that; our turnover rates
are low, our fees are lower than most. We just want to perform
well for our shareholders.
Q. Do you do a lot of in-house research?
M.P. We do all in-house research. We give orders to brokers, and
we see their research and see what they’re saying. But we do most
of our own research. I have a dozen analysts who are terri?c and
we do all our own work.
Q. How important is good research?
M.P. It’s all-important.
Q. Do you market-time at all? Would you go more into cash if you
saw no opportunities?
M.P. That’s how it works. Cash balance goes up if we don’t
?nd stocks. If we ?nd stocks, cash comes down. We don’t come
in saying, “Let’s raise cash.” We come in saying, “Let’s buy
stocks.”
QUESTIONS AND ANSWERS 217Q. Is the hardest part deciding when to sell?
M.P. That’s really hard because you never know what the buyers
are thinking or know how high something may go. What we kind
of do is start selling things when they are about 85 percent of what
we think the company’s value is, and we start selling it slowly each
day, and if it goes higher, great, we get out of it and we don’t look
back.
Q. Do you have stop-loss orders?
M.P. No, but I sit at a trading desk and watch the market all day, so
we’re very set up to pay attention to the stock market. You know,
if you’re a doctor and you must be in surgery and the stock goes
down, you don’t want a big loss, so you’ll have a stop order. But
you can’t be looking at Quotron machines when you’re doing brain
surgery, right? I sit here all day watching the market, so we don’t
need stop orders.
Q. What advice do you have for ordinary investors?
M.P. The most important thing, even though most people won’t
do it, is to read the prospectus. People are lazy. They work re-
ally hard to save the money that they have to invest, then all of a
sudden they become very lazy. Most people don’t want to take
the time to call what is usually an 800 number to get what is
more or less a pretty simple document. You read it, paying atten-
tion to the fees, the terms. The reason you must read it is that
the mutual fund industry has found ways to put in both 12b-1
fees and redemption fees as well as loads on the front end, in
ways you may not be aware. You might put money into a fund
thinking it’s a no-load fund, you see, and you may have missed
the little asterisk which shows you there’s a redemption fee and
after the ?rst four years you redeem, you will have a 4 percent
discount. Well, that’s terrible. So if you read the prospectus,
you’ll know it’s there.
Q. Any other advice?
M.P. Do some of your own research, looking back over what the
guy’s track record was for ?ve and ten years. Five and ten years
gives you bull markets and bear markets, not just bear markets. A
quarter or a one-year performance just isn’t long enough. You need
to look at a record for a minimum of three to ?ve years, if not ten.
You want to know whether it’s been the same guy running it and
then ...
218 MICHAEL PRICE OF THE MUTUAL SERIES FUNDThe next step is to take the time to look at the three, four, or
?ve biggest holdings of the fund. That will give you a sense of
what the guy buys. And read a few articles about these compa-
nies. And before you buy the fund, ask yourself, Do I want to
own these companies? Because in effect you’re owning those
companies, you’re paying a guy a hundred basis points to watch
over it, right?
You know, one of the things we do here from time to time
when the markets are a certain way is, we’ll buy closed-end
funds at 25 percent discounts. Well, the ?rst thing you do is look
at the four or ?ve biggest holdings in the closed-end funds. I re-
member doing this back in 1984; there was a closed-end fund in
London and it was trading at a 25 percent discount; they had 30
percent in cash, and the balance of the portfolio was made up in
liquid U.S. oil and gas companies and Royal Dutch Petroleum.
So, in effect, I was buying Royal Dutch Petroleum at a 25 per-
cent discount. You couldn’t miss—you could not miss, you
know?
But likewise if I hadn’t looked at the holdings, maybe it wouldn’t
have been Royal Dutch, which is the cheapest and the best com-
pany in the world. Maybe it would have been some phony Cana-
dian exploration company that trades on the Vancouver Stock
Exchange for $13 when it’s only worth $2. That’s why you have to
look at what the fund owns....
Q. What lessons have you learned?
M.P. Well, we make lots of mistakes. I mean, the lesson I learned is
this is the way to invest, the value approach. You have to do your
own homework. We learned to be diversi?ed; we own a couple of
hundred different things. It’s very important from time to time to
have plenty of cash; you don’t have to be invested all the time. Be-
ing good all the time is better than being great one year every now
and then....
So, which portfolio manager did Michael Price tell me that he ad-
mired the most? William Ruane.
QUESTIONS AND ANSWERS 219CHAPTER 31
A Variety of Other
Value Investors
Charles Royce
R
unning a mutual fund isn’t as easy as it looks. That’s the dry com-
ment of Charles “Chuck’’ M. Royce, who’s been running small-
company mutual funds for almost 30 years—and very skillfully.
Along with having a nice way with words, Royce is awesomely
smart (he studied with David Dodd, who collaborated with the leg-
endary Ben Graham at Columbia). He’s easy to recognize, too, what
with his ever-present bow ties. He reminds me a bit of Ralph
Wanger, who runs the Acorn funds in Chicago. (They happen to be
good friends, although Wanger is largely growth and Royce is
mainly value.)
I visited Royce at his of?ce on West 58th Street in Manhattan.
Fifteen or so years ago, I had interviewed him for the ?rst time, at
the same place, and I still remember things he had said—he was
that impressive. Most people’s portfolios, he told me, have no
rhyme or reason. They’re a complete mess. (I also asked him what
a “value” investor was. As I recall, he was momentarily shaken by
my ignorance.)
Getting back to the woes of managing a fund: One pitfall is that
the stocks you invest in may be out of favor—as value stocks were
221for several years before the year 2000. Another problem: Running
value funds in particular is never a cakewalk.
“Investing in growth stocks is much more fun,” Royce says can-
didly. “There are lively stories, the stocks are doing well. It’s easy to
get comfortable with the portfolio because they’re important house-
hold names. You all but forget the price you pay. But the price can
screw you up because it may be too high. Still, it’s a reasonable way
to make money.
“With value stocks, at least expectations are low. The price I pay
does count. That way, negative surprises don’t wipe you out. You’ll
lose less. Growth stocks can lose 50 percent or 60 percent of their
value in one day.”
Value investing not only requires more courage; it requires almost
in?nite patience, which sometimes goes unrewarded. Royce may
buy unloved stocks and wait years for them to be recognized. Then
the company’s management, recognizing how cheap the stock is,
steps in to buy the company—very cheaply. Royce’s patience goes
for naught. “It’s a big problem,” he says unhappily.
Then there are redemptions: Disgusted investors begin bailing
out, as Edwin Walczak has complained. One thing about investors
is absolutely certain: Whether it’s stocks or bonds, precious met-
als or frozen pork bellies, they seem determined to buy high and
sell low.
Royce’s funds have suffered less than most other small-company
value funds have, probably because his investors are smarter and
they’re familiar with his ?ne long-term record. Also, his funds—for
small-caps—are surprisingly conservative: Their volatility is star-
tlingly low.
Still, his oldest fund, Pennsylvania Mutual (which dates to 1973),
has lost shareholders—something that happens with older funds as
their investors age, move from stocks to bonds, and buy homes for
their children.
Questions and Answers
Q. Just why did value funds do so poorly for years and years?
C.R. The whole world is cyclical, and growth and value take turns.
It’s the natural order of things.
Q. Why do value players decide to become value players in the ?rst
place?
C.R. After suffering some pain. Often they have lost a good
222 A VARIETY OF OTHER VALUE INVESTORSamount of money. They develop a heavy dose of realism and be-
come sensitive to risk.
Q. What kind of stock do you look for?
C.R. Stocks that just have the ?u, not pneumonia. It could be a ?ne
company whose growth is slowing—from 20 percent a year to 12
percent. And the market has, as usual, overreacted, dropping the
stock’s price-earnings ratio from 25 to 8. But a stock that earns 12
percent at 8 times [earnings] is great.
In general, what he does is buy stocks that have fallen, then sell
them when they have bounced back. Will he sell a small company
that becomes a mid-sized or big company? “That would be absurd,”
he replied, a bit surprised. “We’re trying to make money, not clip the
?owers when they begin blooming. We invest in accord with com-
mon sense.”
At some level, he grants, choosing stocks calls for a little guess-
ing. “At the end of the day,” he confessed, “I ask myself: What will
people think of this stock two years from now? Will people adjust
to its new, lower level of growth? Will it be taken out of the
penalty box?”
In any case, only 20 percent of his choices turn out to be big win-
ners. Still, those winners “have a great deal of effect on the whole
portfolio.”
How does he avoid mistakes, choosing old mutts instead of
healthy puppies? Studying their balance sheets, including the foot-
notes. Visiting companies and talking with management—and talk-
ing with suppliers and competitors. “Management gives you the
party line; competitors tell you the truth.”
His advice to investors: Recognize that a value fund may at any
time be buying cheap stocks (“seeding”) or selling formerly cheap
stocks (“harvesting”). The better time to buy is when stocks in gen-
eral are down and the fund is scooping up bargains. “A period of un-
derperformance is really a time of opportunity.”
Royce’s funds are split between small companies and micro-
caps, diversi?ed funds and concentrated funds. His two recom-
mendations for investors who want small value funds: Royce Total
Return, which enjoys a remarkable stability because it invests in
dividend-paying small companies (yes, there are such things), and
Royce Low Priced Stock Fund, which has done well in part be-
cause so many investors are suspicious of inexpensive stocks—so
you can buy them cheap.
Yes, running a mutual fund may be tough. But Royce acknowledges
QUESTIONS AND ANSWERS 223that “this business is so much fun.” And there are rewards. Investors
expect very little from value funds—and expect the world from
growth funds. Value players “are always getting boos from the
stands.” So, when they go on a bit of a spree, their investors are over-
joyed. Whereas, “With the growth guys, everyone always cheers—but
then they may strike out.”
www.roycefunds.com
Jean-Marie Eveillard
Jean-Marie Eveillard, who was born in France and runs the First
Eagle SoGen funds, was making an appearance on Wall $treet
Week, arguing the case for the bears (this was some years ago).
Logically, persuasively.
And then one of the panelists, a nasty glint in his eye, asked,
“You say you’re so pessimistic about this market now. But how
come you have 30 percent of your investments in the stock
market?” Then he sank back into his seat looking smug and self-
satis?ed.
Said Jean-Marie, evenly, “I may be wrong.”
The panelists, every last one of them, were thunderstruck.
No one had ever, it seems, uttered those words on the program be-
fore. Utter quiet.
And then Jean-Marie added, “I’ve been wrong before.”
I thought all the panelists would now faint dead away. Two con-
secutive statements that you would never expect a portfolio man-
ager to utter. When the panelists regained their senses, they looked
upon Jean-Marie with new-found respect.
Remembering Bernard Baruch
I’ve interviewed Eveillard several times over the years. The ?rst time
I interviewed him, he was not as well-known as he is now. And I
heard that he was boasting to a relative of his, who worked at our
magazine (Sylvia Porter’s Personal Finance Magazine), that we had
just interviewed him. An early taste of fame.
I keenly recall one conversation with him, right after the crash of
1987. His fund wasn’t badly hurt. He’s almost always pessimistic, and
he had been keeping a low pro?le.
“When the market goes up,” he said, “you always wish you had had
more money in the market. When the market goes down, you always
wish you had had less.”
224 A VARIETY OF OTHER VALUE INVESTORSHe added, “I always sell too soon.”
Said I, brightly, “That’s what Bernard Baruch said.”
A pause. “Who is Bernard Baruch?”
Agreeing with Buffett
In 1998 or so, the SoGen funds were doing terribly.
As he pointed out during a speech in New Jersey, he invests not
just in foreign stocks, which were out of favor, but in small-cap
stocks, which were also out of favor, and in value stocks, which
were also out of favor. (SoGen is short for Societe Generale, the
French bank that runs the funds.)
But Eveillard urged people attending the meeting not to assume
that large U.S. growth stocks will continue their reign forever. Ten
years ago, he mentioned, everyone thought the Japanese market was
also invulnerable—before it began sinking beneath the waves. And
now, with the stocks in the Standard & Poor’s 500 Stock Index sell-
ing at 35 times earnings, he suggested, the U.S. market may be simi-
larly overvalued.
Those earnings themselves, Eveillard went on, may be overstated:
Some corporations are “playing around” with their accounting, he
said, just to keep stock prices high. (That famous investor Warren
Buffett, Eveillard mentioned, had said the same thing.) He and Buf-
fett, in fact, share other views. At that meeting, he said, “There is no
such thing as an ef?cient stock market.”
Eveillard is a charming, cultured gentleman, and he still speaks
with a French accent. One of his interests, I happen to know, is at-
tending the Metropolitan Opera.
Five years ago, Eveillard told the investors’ group, too much
money was ?owing into foreign funds, so he closed his own ?agship
fund, SoGen International, to new investors for a while. But in re-
cent years too much money has been leaving. “The lesson that peo-
ple should learn,” he said, “is that you should be very careful not to
extrapolate recent experiences.” Whatever is fashionable now may
not last long.
He urged investors to diversify their portfolios away from just U.S.
large-company growth stocks. “The world is a dangerous place to-
day,” he said. “And not even [Alan] Greenspan [chairman of the Fed-
eral Reserve] walks on water.
“There is an enormous discrepancy between big growth stocks
and small value stocks on the other hand,” he went on. “Quite a few
small value stocks are reasonably priced, nothing like S&P 500
JEAN-MARIE EVEILLARD 225stocks. Either the small caps will catch up, or the big growth stocks
will come down. And in recent weeks, small value stocks seem to
have been catching up.”
What about just buying multinational companies, such as IBM,
which do a lot of business abroad, and avoiding individual foreign
stocks? His answer: “Why close yourself off from potential opportu-
nities?” Europe is only in the early stages of corporate restructuring,
he said, so stocks there may have a rosy future.
On the other hand, stocks in the larger European countries may be
almost as overpriced as U.S. large companies, he warned. “Nestle is
about as expensive as U.S. multinationals.” (Nestle, the chocolate
company, is based in Switzerland.) “But small companies in the
United Kingdom are as cheap as they’ve been in 25 years. And there
are better investment values outside the United States.”
While accounting practices in emerging countries “are some-
times bizarre,” he went on, “the United States is not perfect, ei-
ther.” Some European countries, in fact, “have an extremely
conservative bias.”
About Japan he was guardedly optimistic, saying it would take
time for corporations there to make the “wrenching changes” re-
quired, like laying off unneeded workers. But he predicted that these
things would eventually happen: “The Japanese will let the dice fall
where they may.”
Someone asked Eveillard whether Europe can thrive economi-
cally when workers in Germany take six-week vacations. Eveillard
replied that a six-week vacation isn’t harmful “if during the remain-
ing 46 weeks they work with typical German discipline.”
A few months ago, I had heard Eveillard say that he had sold all
his shares of Johnson & Johnson—which bothered the heck out of
me because I own some shares.
“Why?” I asked.
He had bought it when the two Clintons were making plans to
change the health-care system, he explained, and the stock became
cheap. But now that it’s recovered, he said, it doesn’t belong in a
value-oriented portfolio. “But obviously I sold too soon,” he said, re-
ferring to the stock’s neat performance that year.
SoGen International is still rated four stars, for “above average,”
by Morningstar Mutual Funds, a leading newsletter. Writes Morn-
ingstar, “With Eveillard at the helm, this fund should remain a ?ne
global asset-allocation vehicle.” The SoGen Funds have 3.75 percent
sales charges.
www.?rsteaglefunds.com
226 A VARIETY OF OTHER VALUE INVESTORSWilliam Lippman and Bruce Baughman
What stock might someone buy—and hold forever? A few years ago,
the answer given by Bill Lippman and Bruce Baughman, value in-
vestors at the Franklin Funds, was: Automatic Data Processing,
headquartered in Roseland, New Jersey.
Their reasoning: The stock has raised its dividend for umpteen
consecutive years, the management is shareholder-oriented, and the
payroll business should thrive far into the future.
Do they own it? Nope. “It’s a little high-priced,” Lippman said.
An interesting choice, but something you would expect from these
two savvy guys. Lippman, 76, is president of Franklin Advisory Ser-
vices, part of the huge Franklin Templeton group of funds in San Ma-
teo, California, which now owns the Mutual Series funds in Short
Hills, New Jersey.
Baughman, 52, a CPA, is senior vice president and runs the group’s
?agship fund, Franklin Balance Sheet, which has an unusual 1.5 per-
cent sales charge. He also runs Franklin Microcap Value. Don Taylor,
who came from Fidelity, runs Rising Dividend. (Most Franklin funds
have 5.75 percent loads.)
Lippman has launched a new fund called Franklin Large Cap
Value, which buys large-company stocks. Any real estate investment
trusts? “Never,” Lippman said. “They’re too hard to ?gure out.” And
naturally, they don’t own any pharmaceuticals—too high-priced for
value investors. “I’d like to see them selling at 15 times, not 24,” Lipp-
man said, talking about their price-earnings ratios.
Lippman is a slender, wiry, quick-thinking fellow with a neat
sense of humor. Among the stocks he has bought is TJ Maxx.
“It’s like a museum,” Lippman said. “And the stuff is cheap. You
can get a decent white shirt for $15. And the stock has a high re-
turn on equity.”
He also claims to be a razzle-dazzle tennis player but for years has
politely declined an invitation to play against me. (Very wisely, I
might add.)
The two were in a good mood when we had lunch recently in Fort
Lee, New Jersey, where they work. After several years during which
growth stocks have annihilated value stocks, the sun had begun
peeking through the clouds.
During all those lean years, I asked, had they stuck to their disci-
pline and continued buying only cheap stocks? Weren’t they tempted
to buy Cisco, America Online, and such?
“We remained steadfast,” Lippman said. And he expressed some
skepticism about certain “value” mutual funds that bought stocks
WILLIAM LIPPMAN AND BRUCE BAUGHMAN 227such as AOL and Cisco. (I think this is called “running with the
foxes and hunting with the hounds.”) He described two styles of
“capitulation”: (1) “Buying those ridiculous dot-coms that aren’t
making any money” and (2) “Just not buying good cheap stocks,
like those selling at only six times earnings and below book
(value).”
Baughman added that fund managers have a lot of latitude even if
they’re determined to remain in one corner of the Morningstar style
box. (Managers want to be consistent because ?nancial planners
and pension managers want consistency.) They can just make sure
that their median stock, the one in the middle, is value—if they want
to be classi?ed as value investors.
Lippman started as a mutual fund salesperson, then launched his
own operation: the Pilgrim funds. There he started the ?rst “rising
dividend” fund, MagnaCap, buying stocks of companies in such good
shape that they could boost their dividends regularly.
Franklin Balance Sheet was launched to buy closed-end funds; its
strange sales charge, 1.5 percent, is the highest that a fund can
legally charge if it buys other funds.
What advice would they give beginning investors? “Read Graham
and Dodd,” Lippman replied.
Also: Lippman quoted the late Max Heine, who started the Mu-
tual Series funds, as saying, “Many roads lead to Jerusalem.” Mean-
ing: You can make money many different ways. (Lippman had
organized a memorable panel discussion years ago featuring Heine,
Philip Carret from Pilgrim, and Julian Lerner from the AIM funds.
As I recall it, Heine had actually said, “All roads lead to Jerusalem.”
Not “many.”)
Also: If you’re a value investor, he advised, take a long-term view.
“Buy good quality, low-debt companies. Things may go against you
for a period of time, but if you get suckered out, you’ll never make
money.”
Do they try to assess company management? Yes, and one way to
gauge whether management really cares about shareholders is to
scrutinize proxy statements. Lippman and Baughman check options
awarded, options repriced when the stock didn’t go up, insider sales,
executive pay, whether the chairman’s nephew is on the payroll. I
mentioned that Charles Royce’s complaint that he sometimes holds
a cheap stock for years, only to have management greedily buy the
company for a song and put him out in the cold.
“It happens and we hate it,” Baughman said, clearly annoyed. But
228 A VARIETY OF OTHER VALUE INVESTORSsometimes management is forced to raise the bids when outsiders
get interested.
When management offers to buy the company, he added, it’s
usually a sign that the stock is dirt cheap and better times lie
ahead.
They echoed Royce in agreeing that running open-end mutual
funds is no cakewalk.
“You can’t control the ?ow of money,” Lippman said. If share-
holders sell, you have to raise money. In recent years, with share-
holders leaving, they’ve had to sell good stocks. “We shaved a little
here and there,” he said, hoping that by the end of a month, the
portfolio will look exactly the same—but there will just be fewer
shares of everything.
What do they think of index funds? “A self-ful?lling prophecy,”
Lippman said dismissively. In recent years, everyone has been buy-
ing them, so they went up. “The reverse may also be true.” If the S&P
goes down for a year or two, people may sell their index funds and
buy something else, driving the S&P down even further. (A good rea-
son to buy Vanguard Total Stock Market, I think, rather than the less-
well-diversi?ed S&P 500 index.)
Baughman shrewdly noted that the indexes are always adding hot
stocks and dropping cold ones. “There’s an element of momentum
investing in this, and theoretically it can work in reverse, too,” he
pointed out. The hot stocks may turn cold.
Isn’t their job boring? Just waiting for cold stocks to turn warm?
No, says Baughman, with their portfolio, something is always hap-
pening. That’s a good reason to own a variety of stocks: You don’t
ever have a chance to fall asleep.
How do their funds differ from their sister Mutual Series funds?
Those funds buy more distressed merchandise than they themselves
would.
Do they talk with other value managers at Mutual Series? Not at
all. One reason: A fund is inhibited from owning more than 10 per-
cent of a company. If a Mutual Series fund owns, say, 7 percent of the
shares, Balance Sheet (say) might not be able to buy more than 3
percent—unless the funds keep walls between themselves. Then
each can have up to 10 percent.
Lippman said, “Otherwise, I’d love to compare notes with the peo-
ple at Mutual Series.”
www.franklin-templeton.com
WILLIAM LIPPMAN AND BRUCE BAUGHMAN 229Colin C. Ferenbach
Asked about his investment strategy, Colin C. Ferenbach, co-
manager of the Haven Fund in New York City, explains: “I’m
scared a lot.”
He likes to quote an old adage: “There are old portfolio managers
and there are bold portfolio managers, but no old bold portfolio
managers.” (There is a Morningstar study showing that veteran
money managers tend to be very conservative.)
As one might expect, the Haven Fund is mainly for conservative
investors. Even so, it invests in mid-cap stocks—certainly not so
safe as large companies. But compared with an index of mid-cap
stocks, the Haven Fund is only 77 percent as volatile. Its Morningstar
rating is usually 4 stars—“above average.”
Although it’s more than 15 years old, Haven remains a tiny fund,
with only $90 million in assets. Still, the few hundred shareholders
have an awful lot of con?dence in the fund: They invest an average
of $325,000 each.
Haven almost never appears at the top of the charts, although in
some years it does very nicely indeed: up about 15.91 percent in
2000, a staggering 25.01 percentage points above the S&P 500.
Ferenbach, 67, has a sharp mind and a good sense of humor.
Would he welcome more money and more shareholders into his
fund? His answer: Would he accept a date with Michelle Pfeiffer?
(He answers his own question: “Of course. But she hasn’t asked
me yet.”)
In pursuit of safety, Ferenbach looks for companies that should do
okay in a downturn. “Many funds are like riding a bike downhill. You
can do brilliantly. But when they come to an uphill, they’re no Lance
Armstrong.” (Bicyclist Armstrong won the Tour de France.)
In searching for stocks Ferenbach looks for such things as low
price-earnings ratios, high estimated private market value (what
someone might pay for the whole company), and low debt—and
doesn’t pay much attention to book value (assets per share outstand-
ing) because he thinks it can be manipulated.
Dividends are also nice: “We like to cover our expenses.”
And yes, as often as possible, he talks to the management of a
company he owns or is interested in. In 1977 he attended a dinner in
New Orleans given by the oil company that is now Total Fina Elf.
Only three investors showed up. He was very impressed by the pre-
sentation. He then checked out the company with his friends in
Paris, and bought in—very pro?tably.
230 A VARIETY OF OTHER VALUE INVESTORSWhat turns him off management? “Some people I don’t like or
trust.”
He doesn’t pay attention to market weightings and will sometimes
load up on an out-of-favor sector. In 1998 he was overweighted in
oils; in 1993, pharmaceuticals. “We have a strong contrarian streak.”
When does he sell? “If I feel we’ve made a mistake, we part com-
pany, sooner rather than later. We’re very tax conscious, and we
have no hesitation in cutting losers.” (Losers balance out the capital
gains of winners he’s sold.) He’ll even double-up on a losing stock
that he’s con?dent about, and sell half the shares after 31 days,
which gives him a deductible tax loss and the same investment posi-
tion. (“Doubling up,” it’s called. Unless you wait 31 days before buy-
ing a stock again, you cannot deduct a loss.)
His recent portfolio consisted of only 46 stocks. Around 70 stocks
is the maximum he thinks he could follow.
His worst mistake: buying Owens-Corning. It got creamed because
of asbestos litigation. “It was a cheap stock,” said Ferenbach rue-
fully, “and it got a lot cheaper.”
For help, he relies on regional brokers who follow mid-cap
stocks: “They’re more objective” than analysts at the national
wire-houses.
He himself reads a lot: “I’m always looking to spot good ideas.”
Haven buys and holds stocks—“keeping a stock three years is
nothing,” he says. The fund’s turnover rate in 2000 was 80 percent,
which is the equivalent of his selling fewer than four out of ?ve
stocks during the year. (The average turnover of a mid-cap blend
fund: 104 percent.)
Ferenbach isn’t a big fan of indexing: “It’s beginning to unwind,”
he says skeptically. Momentum investing—where you stick with hot
stocks—is going out of style, he believes, and that’s what has helped
the Standard & Poor’s 500, which has been dominated by a few hot
stocks. “Indexing fed on itself and justi?ed itself.”
Is the stock market going to continue going up 20 percent a year?
“It can’t,” he says. “If it did, everyone could buy the island of Manhat-
tan. It’s been a great run, but it will end in either a bang or a whim-
per. I expect the 2000s will be a re-run of the 1970s, where stocks go
up 3 or 4 percent a year, in?ation-adjusted.”
Haven had been a limited partnership set up by Goldman Sachs
people, and it became an open-end fund in 1994.
Ferenbach graduated from Yale in 1955 with a B.A. in history, and
served in the U.S. Air Force for two years before joining Goldman,
Sachs. He has 43 years of investment experience.
COLIN C. FERENBACH 231Unlike some managers, who seem monomaniacal about investing,
Ferenbach has outside interests. He even owns a vineyard in France,
and loves to talk about the “intriguing mystery” of why some wines
turn out to be superb but not others.
Okay, but what advice does he have for ordinary investors? He
thinks a moment, then says, “Be patient.”
www.havencapital.com/index2.htm
Mario Gabelli
I had asked Mario (the Great) Gabelli to explain his strategy in 25
words or less, and he came up with: “Graham and Dodd plus Warren
Buffett.”
Mario is bursting with energy, bursting with fresh ideas. The kind
of guy who would come to a Barron’s Round Table, during the tech
bubble, carrying a bouquet of ... tulips. (When someone tracked the
stock tips made by the Round Table experts, only Mario acquitted
himself with honor.)
He studied at the Columbia Business School under Roger Murray,
who edited the second edition of Graham and Dodd’s Security
Analysis.
To ?nd stocks to buy, Gabelli looks for companies with a “fran-
chise,” with dominant positions in their markets. Such companies
will survive downturns, and perhaps emerge even stronger. He also
looks at a company’s free cash ?ow, then at its price, to determine
whether he’s buying it at 40 percent or 50 percent off.
Then he looks for a catalyst that will unlock the values. He calls it
“surfacing the values.” (He’s good with words. He once called junk
bonds “stocks in drag.”)
A company might spin off an unpro?table division—appoint
a dynamic new manager—or industry fundamentals just might
improve.
The ?nal test is the balance sheet. He looks for what might
be wrong: unfunded pension liabilities, environmental problems,
lawsuits.
But Super Mario’s genius seems to lie in spotting powerful trends
before others do—such as his seeing how pro?table cable TV com-
panies would become before almost everyone else did.
A second-generation Italian–American, Gabelli grew up in the
Bronx, New York, and though his family was poor, they were fortu-
nate in that they didn’t know it. Long before he obtained his educa-
tion, he says, he had a Ph.D.: He was poor, hungry, and driven. In
232 A VARIETY OF OTHER VALUE INVESTORShiring people, he looks for similar qualities: people who will “sacri-
?ce for success.”
He became interested in investing when he kept overhearing
wealthy investors talk about stocks while he caddied at golf clubs in
Westchester County. He bought his ?rst stocks when he was 13; he
helped ?nance his own education at graduate school by trading
stocks from a phone booth on the Columbia campus.
What mistakes has he made? Sometimes his painstaking re-
search—talking with management, with competitors, digesting
?nancial reports—has him still on the runway when the stock
takes off.
If you ask him whether he market-times or not, he gives a typi-
cal ironic Gabellian reply: “No, I’m not smart enough to market-
time.”
The ?rst time I met him was right after the crash of 1987. I said
to him, “Why does the stock market go up and down? Do you
know?”
He replied, “I’ve been in this business a long time, and I still have
no idea.”
www.gabelli.com
Robert A. Olstein
No less than Marty Whitman has spoken highly of Robert Olstein,
saying that he has a knack for buying good, cheap stocks very early.
Here are a few excerpts from a quarterly report of his:
•“Our simple de?nition of a value investor is one who attempts to
buy stocks selling at a discount to the intrinsic value of the underly-
ing business. Good minds may differ as to what that value may be,
but any fund not paying attention to value (momentum funds or
crowd psychology funds) is relying on the foolishness of other in-
vestors to make money. I prefer to call those funds ‘overvalued
funds.’”
•“Value funds aim to take advantage of misperceived crowd psy-
chology, which causes investors to abandon and ignore valuable
businesses as they seek short-term fortunes in current market fads.
At other times, value is created by temporary problems surrounding
a speci?c company, an industry, or the markets in general. Any nega-
tivity, which is usually highlighted prominently by the analytical
community and the media, goes against the investment crowd’s de-
sire for instantaneous grati?cation, resulting in a mass exodus from
those stocks.”
ROBERT A. OLSTEIN 233•“The three most important factors we consider when purchas-
ing stocks for our portfolio are price, price, and price.”
•“Mispriced securities rarely turn around overnight, as crowd
misperceptions are slow to change.”
•“Momentum investors who trade in overvalued stocks based on
crowd psychology are in essence engaging in a game equivalent to
Russian roulette, hoping that the bullet is not ?red at them.”
•On why his fund has a 150 percent turnover: “When stocks
reach prices in which our risk/reward equation tilts toward risk,
we sell. The long-term holders of great companies such as Cisco,
Microsoft, and Sun Microsystems, which eventually reached unre-
alistic prices, are currently wishing that their funds had more
turnover.”
•Can his fund become more tax-ef?cient? “Absolutely! We can
purchase overvalued stocks, lose money, and reduce your tax bill to
zero. On a serious note, we always review the tax implications of in-
vestment decisions, but will never allow tax decisions to take prece-
dence over investment decisions.”
•Should you wait for a catalyst before you buy a value stock?
“Earlier this year [2001] the Fund owned Shaw Industries, a leading
carpet company, which was purchased at about $13 a share. At the
time ... we believed the stock was worth $20 a share (based on fu-
ture cash ?ows) with long-term appreciation expected from our cal-
culation of private market value. Many analysts agreed with us about
the $20 value but advised investors not to purchase Shaw Industries
for about a year until the earnings turned around. Shaw was experi-
encing what we believed was a temporary earnings downturn....
Unfortunately for the analysts, an investor named Warren Buffett did
not worry about the timing and had a time horizon which extended
well into the future. He made a tender offer for the outstanding
shares of Shaw Industries at $19.25 a share. Mr. Buffett took advan-
tage of the current price....”
www.olsteinfunds.com
John Gunn
The three Dodge & Cox Funds—Stock, Balanced, and Income—are
very similar. Balanced buys the stocks and bonds the other two
funds own. A veteran fund, Balanced ?rst saw the light of day in
1931, and all the funds have rock-solid records.
I interviewed John Gunn, the chief investment of?cer, a few years
ago.
234 A VARIETY OF OTHER VALUE INVESTORSQuestions and Answers
Q. How are the Dodge & Cox funds different from other funds?”
J.G. Among mutual funds, we’re a strange beast. One writer has
even said that Dodge & Cox is not in the mutual fund business—
which is why he likes us. What he meant was that we don’t adver-
tise or bend over backward to publicize ourselves; we’re not in the
distribution business.
It’s true that we’re different. We don’t want to have phalanxes of
people.... We don’t even have any new funds on the horizon, be-
yond the three we have now.
We’re in the investment business, concentrating on stocks and
bonds to buy and trying to keep our costs low....
Our stocks have done well, I think, because of our strong, extensive
research and our determination to understand each investment as
best we can. We’re trying to buy bargains and be well-informed
about those bargains. Then there’s our long-term orientation. And
our low turnover. Also, our employees are active investors in our
company. We eat our own cooking. All of our pension and pro?t-
sharing plans are invested in the three funds.
Our team approach is another advantage. Everyone here started
out at or near the beginning of their business careers, and every-
one shares the same general business philosophy. We’re on the
same wavelength, even though some of us have different camera
angles. All of us are even on one ?oor, so we can meet quickly.
We try to avoid stocks that in three or four years will be known as
value stocks and to buy stocks that we hope someday will be
known as growth stocks—unpopular to not-very-popular stocks
with low-to-average expectations of pro?ts. We’re not knee-jerk
contrarians, but we’re always going to be looking at stocks whose
prices are dropping.
Of course, if a stock is selling at the low end of its historic valuation,
it’s not that everyone else sees worries and we see nothing but
blue skies. The worries are there. But a lot of times they get over-
done. And we also may see chances of good surprises....
www.dodgeandcox.com
QUESTIONS AND ANSWERS 235CHAPTER 32
Putting Everything
Together
T
o invest like Warren Buffett, you have a variety of choices—and
you can mix them up.
•Buy shares of Berkshire Hathaway.
•Buy individual stocks that Berkshire owns, possibly along with
stocks that seem to ?t Buffett’s criteria, possibly along with
stocks in Buffett-like funds, like Clipper, Legg Mason Focus,
and Tweedy, Browne.
•Buy Buffett-like funds themselves.
Traits of Superior Investors
What do superior investors, like Warren Buffett, have in common? A
poll I conducted a few years ago of 24 respected investors*
found
that these were the criteria that value investors considered most im-
portant:
•Sticking with your strategy
•Having better research
•Willingness to be contrarian
•Being logical and unemotional
237•Following a sell discipline
•Experience
•Flexibility
Here are the criteria that growth investors emphasized:
•Sticking with your strategy
•Being logical and unemotional
•Having better research
•Following a sell discipline
•Experience
•Flexibility
•Pulling the trigger quickly and knowledgeably
Which of these criteria seem to apply most to Buffett? Being
logical and unemotional. Sticking with your strategy—although
his strategy did shift, from deep value (those cigars with a few
puffs left in them) to value with a growth tinge. (That shift would
?t under “?exibility.”) A willingness—indeed, an eagerness—to be
contrarian. Experience, certainly. Pulling the trigger quickly—cer-
tainly. Following a sell discipline? Berkshire has actually bought
and sold with more alacrity than investors in general recognize.
Buffett’s favorite holding period may be forever, but not for any
company he thinks has turned into a dog. How about his having
better research? We don’t have in-depth knowledge about his in-
vestigation into certain companies that he has bought, but we do
know that he studies the numbers and he studies the people—and
he will even go to such lengths as to visit a movie theater in Times
Square to see a matinee of Mary Poppins just to gauge the appeal
of Walt Disney stock. In fact, he parted company with Ben Graham
because of his own eagerness to visit companies and interview the
management, which is something that not all value investors care
to do.
All in all, Buffett ?ts these criteria quite nicely—although there are
other criteria as well.
238 PUTTING EVERYTHING TOGETHER
*Among those participating in this poll were James Craig, then with Janus; Richard
Fentin of Fidelity; Mario Gabelli; Warren Lammert of Janus; William Lippman and
Bruce Baughman of Franklin funds; Thomas Marsico; Gary Pilgrim of PBHG;
Michael Price of Mutual Series; Brian Rogers, formerly of T. Rowe Price; Richard
Strong of the Strong Funds; and Donald Yacktman of the Yacktman Funds.Buffett’s Investment Strategy
In Russell Train’s Money Masters of Our Time (HarperBusiness,
2000), he tried to summarize Buffett’s investment strategy, and Buf-
fett himself apparently read over the list with approval:
•You must be a fanatic—“fascinated by the investment process.”
But you cannot be excessively greedy, or not greedy enough.
•Have patience. If you buy a stock, you should not mind if the
stock market closed for 10 years. (This is also an indication of
how much con?dence you have in that stock.)
•Be an independent thinker. Don’t be swayed by what the vulgar
mob thinks. Buffett quotes Benjamin Graham: “The fact that
other people agree or disagree with you makes you neither
right nor wrong. You will be right if your facts and reasoning
are correct.”
•You must have self-con?dence. If you automatically sell when
the stock market or your stocks retreat, out of nervousness,
you’re not behaving rationally. It’s as if you bought a house for
$1 million, and when someone offered you $800,000, you imme-
diately agreed to sell it.
•You must accept the fact that you don’t know something. (The
signi?cance of this seems to be: Either you can’t know every-
thing, and you should go ahead anyway—or, if you don’t know
something, it could be something vital. So be wary.)
•Buy any kind of business, but don’t pay up. Don’t pay too
much and then count on ?nding a “bigger fool to take it off
your hands.”
Train added four more requirements that a good investor along the
lines of Buffett should have:
1.Ten or ?fteen years of study and experience.
2.“Be a genius of sorts.” (Have a special talent for the game.)
3.Be intellectually honest. (Don’t try to delude yourself into
thinking that a mistake you made wasn’t a mistake.)
4.“Avoid signi?cant distractions.” (This might mean: Focus on
the basics—not on secondary or tertiary reasons to buy or not
to buy a stock.)
Train went on to de?ne the “wonderful businesses” that Buffett at-
tempts to buy:
BUFFETT’S INVESTMENT STRATEGY 239•They have a good return on capital, without “accounting gim-
micks” and lots of debt.
•They are easy to understand.
•Their pro?ts are measured in cash.
•They have strong franchises and some freedom to raise prices.
•They don’t need a genius to run them.
•Their earnings are predictable because they’re consistent.
•They are not regulated or targets of regulation.
•They have low inventories and high turnover. They don’t need
large and regular infusions of capital.
•The managers think of shareholders ?rst.
•There’s a high rate of return on inventories plus plant.
•The best businesses grow along with other businesses, with lit-
tle need of their own capital. (Example: advertising)
Final Thoughts on Buffett
•He is determined to invest in almost-sure things. No gambling.
•He concentrates on areas he knows.
•He does his homework.
•He insists on working with people he trusts and admires.
•He’s good at evaluating people.
•He ruthlessly studies his mistakes and tries to learn from
them.
•He’s no Nervous Nellie, ready to trade his securities for little or
no reason at all.
•While he isn’t Simon Legree, he does put his shareholders’
interests before other people’s interests—employees, for
example.
•He doesn’t make the foolish mistakes that ordinary investors
make.
•He’s uncannily knowledgeable about a wide variety of American
companies.
•He has a splendid reputation, lots of charm, and lots of
friends.
•He is modest and humble, but also self-con?dent—at the appro-
priate times.
240 PUTTING EVERYTHING TOGETHER•He’s an unconventional, skeptical thinker. He distrusts popular
opinion. “In my opinion,” he has written, “investment success
will not be produced by the price behavior of stocks and mar-
kets. Rather an investor will succeed by coupling good busi-
ness judgment with an ability to translate his thoughts and
behavior from the super-contagious emotions that swirl about
the marketplace.”
FINAL THOUGHTS ON BUFFETT 241APPENDIX 1
Wanted: Cheap,
Good Companies
When Berkshire Hathaway does things, it does them simply and
sensibly. It wants to buy good businesses, preferring to become
100 percent owners to becoming partial owners just by purchasing
stock. So Berkshire has promulgated an advertisement, printed be-
low, seeking sellers.
Notable Is Berkshire’s Interest in Companies
•with “[d]emonstrated consistent earning power.” Pie in the here and
now, not pie in the sky.
•“Businesses earning good returns on equity.”
•“... employing little or no debt.” Why not seek perfection?
•“Management in place.” Changing horses in midstream is especially
unwise when those horses have proved their merit.
•“Simple businesses ...” The less you understand about a business,
very likely the more nasty surprises lie in store.
•“An offering price. ...” In bargaining, you might try to tie up your op-
posite number’s time. The more of his or her time you waste, the
more eager he or she may be to arrange some sort of deal, any deal.
It’s better to wind up being paid $5 an hour than nothing an hour.
Berkshire doesn’t want to fall into this trap and waste a single mo-
243ment of its time. Once Berkshire has obtained an offering price, it
can just walk away if the seller is asking for too much. If the price is
reasonable, Berkshire can try to bargain the seller down.
In short, Berkshire’s Help Wanted ad is representative of what
Warren Buffett is seeking in any business he invests in: something as
close to perfection as possible. Almost a sure thing.
Berkshire’s Acquisition Criteria
We are eager to hear from principals or their representatives about
businesses that meet all of the following criteria:
•Large purchases (at least $50 million of before-tax earnings)
•Demonstrated consistent earning power (future projections are
of no interest to us, nor are “turnaround” situations)
•Businesses earning good returns on equity while employing lit-
tle or no debt
•Management in place (we can’t supply it)
•Simple businesses (if there’s lots of technology, we won’t under-
stand it)
•An offering price (we don’t want to waste our time or that of the
seller by talking, even preliminarily, about a transaction when
price is unknown)
The larger the company, the greater will be our interest. We would
like to make an acquisition in the $5–$20 billion range. We are not
interested, however, in receiving suggestions about purchases we
might make in the general stock market.
We will not engage in unfriendly takeovers. We can promise com-
plete con?dentiality and a very fast answer—customarily within ?ve
minutes—as to whether we’re interested. We prefer to buy for cash,
but will consider issuing stock when we receive as much in intrinsic
business value as we give.
Charlie [Munger, Buffett’s partner] and I frequently get ap-
proached about acquisitions that don’t come close to meeting our
tests: We’ve found that if you advertise an interest in collies, a lot of
people will call hoping to sell you their cocker spaniels. A line from a
country song expresses our feelings about new ventures, turn-
arounds, or auction-like sales: “When the phone don’t ring, you’ll
know it’s me.”
244 WANTED: CHEAP, GOOD COMPANIESAPPENDIX 2
Berkshire
Hathaway’s
Subsidiaries
(2000)
Acme Building BrandsH.H. Brown Shoe Company
Ben Bridge JewelerInternational Dairy Queen, Inc.
Benjamin Moore & Co.Jordan’s Furniture
Berkshire Hathaway GroupJustin’s Brands
Borsheim’s Fine JewelryLowell Shoe Company
Buffalo News, Buffalo, N.Y.MidAmerican Energy Holdings
Company
Central States Indemnity National Indemnity Company
Company
CORT Business ServicesNebraska Furniture Mart
Dexter Shoe CompanyPrecision Steel Warehouse, Inc.
Executive JetRC Willey Home Furnishings
Fechheimer Brothers CompanyScott Fetzer Companies
FlightSafetySee’s Candy Shops
GEICO Direct Auto InsuranceShaw Industries
General & Cologne Re GroupStar Furniture
Helzberg DiamondsUnited States Liability Insurance
245APPENDIX 3
Quotations from
the Chairman
“I’m rational. Plenty of people have higher IQs and plenty of people
work more hours, but I’m rational about things. You have to be able
to control yourself; you can’t let your emotions get in control of
your mind.”
“The most important quality for an investor is temperament, not
intellect. You don’t need tons of IQ in this business. You don’t have
to be able to play three-dimensional chess or duplicate bridge. You
need a temperament that derives great pleasure neither from being
with the crowd nor against the crowd. You know you’re right, not
because of the position of others but because your facts and your
reasoning are right.”
“I have never met a man who could forecast the market.”
“Coke is exactly the kind of company I like. I like products I can
understand. I don’t know what a transistor is, but I appreciate the
contents of a Coke can. Berkshire Hathaway’s purchase of stock in
246the Coca-Cola Company was the ultimate case of me putting my
money where my mouth was.”
(On Gillette) “It’s pleasant to go to bed every night knowing there
are 2.5 billion males in the world who will have to shave the next
morning.”
“We’ve done better by avoiding dragons than by slaying them.”
“Look at stocks as businesses, look for businesses you understand,
run by people you trust and are comfortable with, and leave them
alone for a long time.”
Notable conversation:
MARSHALL WEINBERG (a broker who had taken Graham’s course): Why
don’t we go to a Japanese steakhouse today for lunch?
BUFFETT:Why don’t we go to Reuben’s? (An East Side deli)
WEINBERG:We ate there yesterday!
BUFFETT:Right. You know what you’re getting.
WEINBERG:By that logic, we’d go there every day.
BUFFETT:Precisely. Why not eat there every day?
“Bull markets can obscure mathematical laws, but they cannot re-
peal them.”
“Berkshire is selling at a price at which Charlie and I would not con-
sider buying it.” (When the stock split into A and B shares, in 1995.)
“In my early days as a manager I, too, dated a few toads. They
were cheap dates—I’ve never been much of a sport—but my results
matched those of acquirers who courted higher-priced toads. I
kissed and they croaked.”
“Charlie and I have found that making silk purses out of silk is the
best that we can do; with sow’s ears, we fail.”
QUOTATIONS FROM THE CHAIRMAN 247“All I want is one good idea every year. If you really push me, I
will settle for one good idea every two years.”
“Sound investing can make you very wealthy if you’re not in too
big a hurry.”
“From [Fisher] I learned the value of the ‘scuttlebutt’ approach: Go
out and talk to competitors, suppliers, customers to ?nd out how
an industry or a company really operates.”
“Graham’s premise was that there would periodically be times
when you couldn’t ?nd good values, and it’s a good idea to go to the
beach.”
“There seems to be some perverse human characteristic that likes
to make easy things dif?cult.”
“This is the cornerstone of our investment philosophy: Never count
on making a good sale. Have the purchase price be so attractive
that even a mediocre sale gives good results.”
“With enough inside information and a million dollars, you can go
broke in a year.”
“[O]ccasional outbreaks of the two supercontagious diseases, fear
and greed, will forever occur in the investment community.”
“We don’t get into things we don’t understand. We buy very few
things but we buy very big positions.”
“Intelligent investing is not complex, though that is far from say-
ing that it is easy. What an investor needs is the ability to cor-
rectly evaluate selected businesses. Note the word ‘selected’: You
don’t have to be an expert on every company, or even many. You
only have to be able to evaluate companies within your circle of
248 QUOTATIONS FROM THE CHAIRMANcompetence. The size of the circle is not very important; knowing
its boundaries, however, is vital.”
“Your goal as an investor should simply be to purchase, at a ratio-
nal price, a part interest in an easily-understandable business
whose earnings are virtually certain to be materially high ?ve, ten
and twenty years from now. Over time, you will ?nd only a few
companies that meet these standards—so that when you see one
that quali?es, you should buy a meaningful amount of stock. You
must also resist the temptation to stray from these guidelines: If
you aren’t willing to own a stock for ten years, don’t even think
about owning it for ten minutes.”
“I’d be a bum on the street with a tin cup if the market were always
ef?cient.”
“We like stocks that generate high returns on invested capital
where there is a strong likelihood that it will continue to do so. For
example, the last time we bought Coca-Cola, it was selling at about
23 times earnings. Using our purchase price and today’s earnings,
that makes it about 5 times earnings. It’s really the interaction of
capital employed, the return on that capital, and future capital
generated versus the purchase price today.”
“Anything is a buy at a price.”
“If the business does well, the stock eventually follows.”
“As long as we can make an annual 15 percent return on equity, I
don’t worry about one quarter’s results.”
“If [the true value of a company] doesn’t just scream at you, it’s
too close.”
“I probably have more friends in New York and California than
here, but this [Omaha] is a good place to bring up children and a
good place to live. You can think here. You can think better about
QUOTATIONS FROM THE CHAIRMAN 249the market; you don’t hear so many stories, and you can just sit
and look at the stock on the desk in front of you. You can think
about a lot of things.”
“Would you believe that a few decades back they were growing
shrimp at Coke and exploring for oil at Gillette? Loss of focus is
what worries Charlie and me when we contemplate investing in
businesses that in general look outstanding.”
“I keep an internal scoreboard. If I do something that others don’t
like but I feel good about, I’m happy. If others praise something I’ve
done, but I’m not satis?ed, I feel unhappy.”
“You don’t have to make it back the way you lost it.”
[His favorite companies are like] “wonderful castles, surrounded
by deep, dangerous moats where the leader inside is an honest and
decent person. Preferably, the castle gets its strength from the ge-
nius inside; the moat is permanent and acts as a powerful deter-
rent to those considering an attack; and inside, the leader makes
gold but doesn’t keep it all for himself. Roughly translated, we like
great companies with dominant positions, whose franchise is
hard to duplicate and has tremendous staying power or some per-
manence to it.”
“You need a moat in business to protect you from the guy who is
going to come along and offer it [your product] for a penny
cheaper.”
“In investments, there’s no such thing as a called strike. You can
stand there at the plate and the pitcher can throw a ball right down
the middle, and if it’s General Motors at 47 and you don’t know
enough to decide on General Motors at 47, you let it go right on by
and no one’s going to call a strike. The only way you can have a
strike called is to swing and miss.”
250 QUOTATIONS FROM THE CHAIRMAN“I’ve never swung at a ball while it’s still in the pitcher’s glove.”
[Graham] said you should look at stocks as small pieces of the
business. Look at [market] ?uctuations as your friend rather than
your enemy.”
“Read Ben Graham and Phil Fisher, read annual reports, but don’t
do equations with Greek letters in them.”
“Of course some of you probably wonder why we are now buying
Capital Cities at $172.50 per share given that this author, in a
characteristic burst of brilliance, sold Berkshire’s holdings in the
same company at $43 a share in 1978–1980. Anticipating your
question, I spent a lot of time working on a snappy answer that
would reconcile these acts. A little more time, please.”
“Diversi?cation is a protection against ignorance. [It] makes very
little sense for those who know what they are doing.”
“A lot of great fortunes in the world have been made by owning a
single wonderful business. If you understand the business, you
don’t need to own very many of them.”
(On owning many stocks, quoting showman Billy Rose) “If you
have a harem of 40 women, you don’t get to know any of them very
well.”
“Ben Graham wanted everything to be a quantitative bargain. I
want it to be a quantitative bargain in terms of future streams of
cash. My guess is the last big time to do it Ben’s way was in ’73 or
’74, when you could have done it quite easily.”
QUOTATIONS FROM THE CHAIRMAN 251“Great investment opportunities come around when excellent com-
panies are surrounded by unusual circumstances that cause the
stock to be misappraised.”
“It’s not risky to buy securities at a fraction of what they’re worth.”
“You have to think for yourself. It always amazes me how high IQ
people mindlessly imitate. I never get good ideas talking to other
people.”
“To invest successfully, you need not understand beta, ef?cient
markets, modern portfolio theory, option pricing or emerging
markets. You may, in fact, be better off knowing nothing of these.
That, of course, is not the prevailing view at most business
schools, whose ?nance curriculum tends to be dominated by such
subjects. In our view, though, investment students need only two
well-taught courses—How to Value a Business, and How to Think
about Market Prices.
“We try to price, rather than time, purchases. In our view, it is
folly to forgo buying shares in an outstanding business whose
long-term future is predictable, because of short-term worries
about an economy or a stock market that we know to be unpre-
dictable. Why scrap an informed decision because of an unin-
formed guess?
“We purchased National Indemnity in 1967, See’s in 1972, Buf-
falo News in 1977, Nebraska Furniture Mart in 1983, and Scott
Fetzer in 1986 because those are the years they became available
and because we thought the prices they carried were acceptable. In
each case, we pondered what the business was likely to do, not
what the Dow, the Fed, or the economy might do.
“If we see this approach as making sense in the purchases of
businesses in their entirety, why should we change tack when we
are purchasing small pieces of wonderful businesses in the stock
market?”
“We do not need more people gambling on the nonessential instru-
ments identi?ed with the stock market in the country. Nor brokers
who encourage them to do so. What we need are investors and ad-
252 QUOTATIONS FROM THE CHAIRMANvisers who look at the long-term prospects for an enterprise and in-
vest accordingly. We need the intelligent commitment of capital,
not leveraged market wagers. The propensity to operate in the in-
telligent, prosocial sectors of capital markets is deterred, not en-
hanced, by an active and exciting casino operating somewhere in
the same arena, utilizing somewhat similar language, and ser-
viced by the same workforce.”
“The business is wonderful if it gives you more and more money
every year without [your] putting up anything—or very little.
And we have some businesses like that. A business is also wonder-
ful if it takes money, but where the rate at which you reinvest the
money is very satisfactory. The worst business of all is the one
that grows a lot, where you’re forced to grow just to stay in the
game at all and where you’re reinvesting the capital at a very low
rate of return. And sometimes people are in those businesses
without knowing it.”
“If you own See’s Candy, and you look in the mirror and say, “Mir-
ror, mirror on the wall, how much do I charge for candy this fall?”
and it says, ‘More,’ it’s a good business.”
“I don’t think you can really be a good investor over a broad range
without doing a massive amount of reading. You might think
about picking out ?ve or ten companies where you feel quite fa-
miliar with their products, but not necessarily so familiar with
their ?nancials. ... Then get lots of annual reports and all of the
articles that have been written on those companies for ?ve or ten
years ... Just sort of immerse yourself. And when you get all
through, ask yourself, ‘What do I not know that I need to know?’
Many years ago, I would go around and talk to competitors and
employees ... I just kept asking questions ... It’s an investigative
process—a journalistic process. And in the end, you want to write
the story. ... Some companies are easy to write stories about and
other companies are much tougher to write stories about. We try
to look for the ones that are easy.”
“The most common cause of low prices is pessimism—some-
times pervasive, sometimes speci?c to a company or industry.
We want to do business in such an environment, not because we
QUOTATIONS FROM THE CHAIRMAN 253like pessimism but because we like the prices it produces. It’s op-
timism that is the enemy of the rational buyer.
“None of this means, however, that a business or stock is an in-
telligent purchase simply because it is unpopular; a contrarian
approach is just as foolish as a follow-the-crowd strategy. What’s
required is thinking rather than polling. Unfortunately, Bertrand
Russell’s observation about life in general applies with unusual
force in the ?nancial world: “Most men would rather die than
think. Many do.’”
“Everyone has the same objective—to end up with more dough
than they start with [with] a minimum of risk.”
254 QUOTATIONS FROM THE CHAIRMANAPPENDIX 4
“65 Years on
Wall Street”
*
I
had a friend who was a therapist at a mental hospital, and he asked
me if I would talk to his patients about investments. And I said
okay, and he introduced me, and so I started to talk about invest-
ments. And after a few minutes a big fellow in the front of the audi-
ence got up and said, “Shut up you idiot and sit down!” I looked at
my friend and I said, “What do I do?” He said, “Sit down. That’s the
most intelligent thing that fellow’s said in months.”
Well, I want to talk about Ben Graham because he was very help-
ful to me and I think it might be interesting to you to know how he
started. Well, we know about his background at Columbia, but he
got the job and became a manager of money because he was very in-
telligent about his investments, and in the 1920s he had a deal where
he took 50 percent of the pro?ts but he also took 50 percent of the
losses. And that worked great until 1929 when the market went
down and obviously his stocks were affected, too, and he was not
only affected by that, but many of these people pulled out because
they needed money for their own purposes, or they had lost a lot of
money in other places.
255
*Remarks by Walter Schloss, founder, Walter & Edwin Schloss Associates, before
Grant’s Interest Rate Observer investment conference, November 1998.So he ?gured out how he could possibly never have this happen to
him again. He was very upset about losing money. A lot of us are. So
he worked on a number of ways of doing this, and one of them was
buying companies [selling for] below working capital, and in the
1930s there were a lot of companies that developed that way. And
then in 1936 he formed a company called Graham–Newman, which
was, I’d say, an open- and closed-end company in that he was able to
open it up to his stockbrokers and he’d sell stock with the rights to
buy new stock below asset value. That is, if you didn’t exercise your
option, you were able to sell the rights for money.
At the beginning of 1946, I was out of the army and Graham hired
me to work for him as a security analyst, and Graham–Newman was
then ten years old and had a nice record. One of the reasons they
had a nice record was that they had bought these secondary stocks
which had big book values but not particularly good earnings. When
the war came along he was able to pro?t from this because the ex-
cess-pro?ts taxes really hurt the companies with small book values.
But the big book-value stocks were in the war, and so they made a
lot of money based upon the fact that they didn’t have to pay these
excess-pro?ts taxes. And those stocks went up and he did very well.
Ben realized that most of them had gone to prices that were no
longer cheap, and so he sold a great many of them.
So, when I came to work for Ben, he had 37 stocks in his common
stock portfolio. That was a really big investment company. They had
$4,100,000, of which $1.1 million was in common stocks. I looked at
the portfolio and I saw that of their 37 stocks that were in the portfo-
lio as of January 31, 1946, only two of them are still around. All the
others were taken over, merged, disappeared. And the only two—
one was Tricontinental Corporation and the other was McGraw-Hill.
He had very small amounts of these stocks, and you ?gure
$1,100,000 with 37 stocks, it wasn’t very much.
They weren’t all industrials. He had investment company stocks
and he had some American Surety, and other insurance company
stocks. Basically, the rest of his portfolio was made up of bankrupt
bonds, against which he sold “when-issued” securities, some con-
vertible preferred stocks where he shorted the common stocks
against them. In those days, if the stock went up you took a long-
term gain on the pro?t side for the preferred, and you took a short-
term loss on the short side, which was a pretty good deal for
them—and, of course, that isn’t true anymore.
Anyhow, at that time my job was to ?nd stocks which were under-
256 “65 YEARS ON WALL STREET”valued. And we looked at stocks selling below working capital,
which were not very many. Among them, for example, was a stock
like East Washing Machine A. The B stock was all owned by the
management or owners. You might know that back in the 1940s a lot
of companies were family controlled. There was a play about ten
years ago called Other People’s Money. It played off-Broadway, and
it was about a little company in New England that struggled along,
the family controlled it, and they weren’t making any money but they
didn’t want to put any more money in it because it was a marginal
business. And what happened is a fellow from New York comes up
and he offers them a pretty good price to buy the company, but the
president doesn’t want to sell. There was a lot of double-crosses, and
it ends up that the family sells out to this guy from New York, who
then liquidates the company, throws people out of work. But the
family made money out of it.
I was reminded of that by some of the things that have happened
over the years since then. In the case of Warren Buffett, who every-
body knows or has heard of if they don’t know him, Warren told me
a story I thought was kind of interesting. He owned a lot of Berk-
shire Hathaway. He probably paid $8 to $10 a share for it. He went up
to the management and spoke to the president about his selling a
block of stock back to the company. (The company had previously
repurchased stock.) The president agreed to buy it back from War-
ren at $11.50 a share.
Well, Warren got that tender offer. It came in at $113
/8—and War-
ren was sore. So he bought control of the company. So sometimes
if you miss something at an eighth of a point, you might think
about that.
One of the experiences I had when I worked for Ben was that he
had very strict rules. He wasn’t going to deviate. I had a fellow come
to me from Adams & Peck. ... A nice guy, he said, “The Battelle In-
stitute has done a study for the Haloid Company,” a company in
Rochester that had paid a dividend through the depression, a small
company that made photographic paper for, I think, Eastman Ko-
dak. Haloid had the rights to a new process and he wanted us to buy
the stock. Haloid sold at between $13 and $17 a share during the de-
pression, and it was selling at $21. This was probably about 1947,
1948 or something like that. I thought it was kind of interesting.
You’re paying $4 for this possibility of a copying machine which
could do this. Battelle thought it was OK. I went into Graham and
said, “You know, you were only paying a $4 premium for a company
“65 YEARS ON WALL STREET”
257that has a possibility of a good gain.” And he said, “No, Walter, it’s
not our kind of stock.”
And, of course, it was Xerox.
So, you can see, he was pretty set.
The only consolation I had on that one was that I was almost sure
that if they had bought this stock at $21 and it had gone to $50, they
would have sold it because they did not project what the thing could
do. And one of the things about these undervalued stocks is that you
can’t really project their earnings. There are stocks where there’s
growth, and you project what’s going to happen next year or in ?ve
years. Freddie Mac or one of these big growth companies, you can
project what they’re going to do. But when you get to secondary
companies, they don’t seem to have that ability. You can’t really say,
Well, next year they’re going to do well because this year they did
poorly, and they’re secondary stocks.
And one of the things we then try to do is to buy a secondary stock
that’s depressed. And today, because of the high level of the stock
market, almost everything’s been picked over. You’ve got some ana-
lysts, 34,000 Chartered Financial Analysts, you have a tough time
?nding something to buy.
I’ll give you one, which you probably won’t like, which would be
typical of an undervalued stock. It’s been mentioned before by oth-
ers and it’s a stock that was at one time in the Dow Jones Average.
It’s come upon evil days and struggle, and nobody likes the industry,
and so forth. But the stock sells at about $21 a share, and it has a
book value of about $40 a share. It got down to maybe $17 when the
market broke a few months ago. It’s a copper company called
Asarco, which just cut its dividend in half.
Now, that stock has got a lot of assets in Peru. They have some big
copper mines there. And nobody likes it because it doesn’t have
growth. But I think Asarco is cheap. We own some, and so I don’t
want you to think I’m pushing it just because I own it. But I thought
you might be interested in the kind of stock I’m talking about.
We bought a lot of these stocks for Ben Graham. We would buy a
lot of those undervalued stocks, and they’d work out, and then we’d
sell them.
The great example, as you probably know, was one company that
sold at $45 a share with a book value of $20, and then [Graham]
would use the example of a company selling at $20 with a book value
of $40, and of course it was the same company, Boeing Airplane. And
Boeing Airplane, before World War II, sold at a big premium over its
258 “65 YEARS ON WALL STREET”assets because it had a great future. But in 1946 nobody wanted Boe-
ing Airplane because they didn’t think it had much of a future.
We would have liked to buy Boeing when it was selling at $20 with
a book of $40, but not the other way around. And I don’t know many
people here who tend to buy companies which are having problems.
One of the reasons is that if you buy a company that’s having a prob-
lem and you have customers, they don’t like that. They want to own
companies that are doing well. You’re going against human nature
when you buy companies which are having problems, and one of the
things we do in our ?eld is buy stocks on the way down. If we buy a
stock at $30 and it goes to $25, we’ll buy more.
A lot of people don’t like it if you buy a stock at $30 for a cus-
tomer, and they see it at $25. You want to buy more of it at $25. The
guy doesn’t like that and you don’t like to remind him of it.
So one of the reasons I think that you have to educate your cus-
tomers or yourself, really, is that you have to have a strong stomach
and be willing to [sit with] an unrealized loss. Don’t sell it, but be
willing to buy more when it goes down—which is contrary to what
people do in this business.
Ben was really a contrarian, but he didn’t use those terms because
he was really buying value. And when I went to work for him, there
were many people doing this kind of thing, buying stocks on the way
down. ...
I tried to follow Ben Graham’s ideas of doing it that way. And, of
course, it’s much more dif?cult now because you don’t have that group
of companies selling below working capital. You ?nd a company selling
below book value, that’s very unusual, and usually the ones that do
have a lot of problems—and people don’t like to buy problems.
The big thing in the way we invest is to buy against price, and Gra-
ham said, in The Intelligent Investor, you buy stocks the way you
buy groceries, not the way you buy perfume. Now, that doesn’t seem
so good today because the Gillettes and the Coca-Colas are the per-
fume stocks. But basically we like to buy stocks which we feel are
undervalued, and then we have the guts to buy more when they go
down. And that’s really the history of Ben Graham.
Questions and Answers
Q. Now, it is often said that the market sometimes knows more
than the investors. So when a stock goes down, could that mean
that you’ve got the analysis wrong? You’re supposed to get out?
QUESTIONS AND ANSWERS 259W.S. Well, that could happen. You have to use your judgment and
have the guts to follow through. And the fact that the market
doesn’t like it doesn’t mean you’re wrong. But, again, everybody
has to make their own judgments on this. That’s what makes the
stock market very interesting—because they don’t tell you what’s
going to happen till later.
Q. There were a group of you that all learned under Ben Graham,
and you all seem to be incredibly successful investors. What do
you think is the common thread amongst all of you?
W.S. I think, Number One, none of us smoked. ... I think if I had to
say it, I think we were all rational. I don’t think that we got emo-
tional when things went against us, and of course Warren is the
extreme example of that.
I think we were all nice guys, and I think we were honest. I don’t
think we had—you know, there are people who’ve made a lot of
money who I wouldn’t want to invest with because they just aren’t
trustworthy, and you probably know who they are. And some of
those stocks sell at low prices because other people feel the same
way. And I would say that this was a good group of people, and
Warren was very nice about inviting us [to a reunion] every two
years, we’d have a meeting somewhere. ...
Q. Japan today has a lot of cheap stocks, but there seems to be lit-
tle corporate governance. Would you bother?
W.S. My problem with foreign companies is that I do not trust the
politics. I don’t know enough about the background of the compa-
nies. I must tell you, I think the SEC does a very good job, and I
feel more comfortable holding an American company. ...
Q. People like to try to ?nd comparisons between today’s market
and markets in the past. Do you see any repetition in history, any
year that this year’s evaluations remind you of?
W.S. Well, I’ll tell you, at the end of last year I refused to accept
money for our partnership because I felt I had no idea what the
market was going to do. I couldn’t ?nd anything to buy. My son
couldn’t ?nd anything to buy. So he said, “If we can’t ?nd any-
thing to buy, why should we take our clients’ money?” So we
didn’t. And to that extent, I thought last year the market was
overvalued. ...
Each market is different, you know? The ?rst stock I bought
back in 1955 when we started the partnership [was Fownes Broth-
ers Gloves] at 21
/2. Tweedy, Browne bought it for me, and it went
260 “65 YEARS ON WALL STREET”up to $23 and I sold it. I had a lot of it and we sold it. And then I
couldn’t buy it back. It didn’t go down as far and it dried up. So it
?nally did sell out around $32 a number of years later. Sometimes
you have to take advantage of the opportunity to sell and then say,
OK, it’ll go higher. Since we sell on a scale, most of the stocks we
sell go up above what we sold them at. You know, you never get
the high and you never get the low.
Q. What is your sell discipline, and how has it changed?
W.S. Selling is tough. It’s the worst, the most dif?cult thing of all.
... We owned Southdown. It’s a cement company. We bought a lot
of it at 21
/2. Oh, this was great. And we doubled our money, and we
sold it at something like $28 or $30 a share, and that was pretty
good in two years. When next I looked, it was $70 a share. So you
get very humbled by some of your mistakes. But we just felt that
at that level it was not cheap.
Q. Has your approach changed signi?cantly?
W.S. Yes, it’s changed because the market’s changed. I can’t buy
any working capital stocks anymore so instead of saying, Well, I
can’t buy ’em, I’m not going to play the game, you have to decide
what you want to do. And so we’ve decided that we want to buy
stocks if we can that are depressed and have some book value and
are selling near to their lows instead of their highs and nobody
likes them. Well, why don’t they like them? And then you might
say there may be reasons why. It may simply be they don’t have
any earnings and people love earnings. I mean that’s, you know,
the next quarter that’s the big thing and, of course, we don’t think
the next quarter is so important.
Q. Tweedy, Browne is very quantitative, and Buffett’s more qualita-
tive. Where are you in that spectrum?
W.S. I’m more in the Tweedy, Browne side. Warren is brilliant,
there’s nobody ever been like him, and there never will be any-
body like him. But we cannot be like him. You’ve got to satisfy
yourself on what you want to do. Now, there are people that are
clones of Warren Buffett. They’ll buy whatever Warren Buffett has.
Fine. I don’t know, I don’t feel comfortable doing that and the
other thing is this. We happen to run a partnership and each year
we buy stocks and they go up, we sell them, and then we try to
buy something cheaper.
Now, if we buy a stock, I mean had only Warren Buffett stocks,
and the stock was Freddie Mac and it goes from $10 to $50. Boy,
QUESTIONS AND ANSWERS 261that’s a great deal. We sell it. But if you don’t sell it and then the
market changes and Freddie Mac goes down from $50 to $25, my
partners they lost 50 percent—that year we lost 30 percent of
our money on our securities. They’d all pull out because you
can’t lose 30 percent. And Charlie Munger actually lost 30 per-
cent of his money two years in a row when he was managing his
own money.
So that you have to be a little aware of the emotions of the peo-
ple who have invested with you. And they trust you, but they
don’t like to lose 30 percent of their money. And we won’t lose 30
percent of our money. And if you buy these high-grade companies
which have a growth factor, they can take a beating and our in-
vestors are not sophisticated and therefore we try to protect
them because we get a percentage of the pro?ts, but we take a
percentage of the losses. But they don’t really, they aren’t really
happy if they lose that kind of money. So I don’t feel comfortable
with them.
But there are people that have made a great deal of money with
them. So, again, you have to invest the way that’s comfortable for
you. And the way that’s comfortable for us is to buy stocks where
we have a limited risk and we buy a lot of stocks. Well, Warren, or
somebody, said, Owning a group of stocks is a defense against ig-
norance, which I actually think that’s to some extent true because
we don’t go around visiting companies all over the country and Pe-
ter Lynch did. He was killing himself. He was seeing 300 compa-
nies a year and he was running from one company to another and
what’s that going to do?
We’re not set up that way. And Graham wasn’t. And Graham’s
argument was that the directors of these companies are responsi-
ble for their success. If the company isn’t doing well, change the
management, do things that make the company do a better job.
And it takes longer that way. No company wants to lose money
continually. They’re going to do something, but you do get
changes in the way companies are operated. ... They’ll either
merge or they’ll change the management. So we do not spend a
great deal of time talking to management or talking to our part-
ners—we don’t want to talk to our partners at all.
Emotionally, I ?nd the stock market can be very unpleasant and
I don’t want to listen to people’s cries. If they’re unhappy—you
may not be in that position to do that, but we are and I just don’t
want to listen to them. If they don’t want it, out. But we do the
262 “65 YEARS ON WALL STREET”best we can for what we are doing, and I feel that you have to un-
derstand where we’re coming from and basically trust us because
we’ve been doing this now for 40, about 43 years. So they just have
to stay with us, hopefully.
Q. How much turnover have you had?
W.S. I guess 20 percent or 25 percent a year. About every four
years we turn over. We want to get long-term capital gains, and
when you buy a depressed company, it’s not going to go up right
after you buy it, believe me. It’ll go down. And therefore you have
to wait a while for that thing to go around, and it seems about,
four years seems to be about the amount of time it takes. Some
take longer. We have one stock, peculiarly enough, I bought from
Warren Buffett. He owed me a favor and he had a group of
stocks—very small amounts of each one—and he came to me
back in 1963 and he said, “Walter, would you like to buy these
companies?” I forget their names. Genesee & Wyoming Railroad I
remember was one of them.
And I said, “Well, Warren, what price are you carrying them
for?” And he told me. He said “I’ll sell ’em to you at the price I’m
carrying them for.” I said, “Okay, Warren, I’ll buy it.” That doesn’t
sound like a lot, but in those days it was, you know, $65,000. It
wasn’t a lot of money for those ?ve companies, and we sold every-
thing over the years. They all worked out beautifully, and we have
one left and it’s called Merchants National Properties and they just
had a tender offer. I paid $14 for the stock. They want to buy this
at $553 a share. So you can see in these little companies there was
a great chance to make money. But that’s almost 35 years ago.
Q. Buffett keeps talking about a handful of thick bets. It sounds
like you don’t do that.
W.S. Oh, no, we can’t. Psychologically I can’t, and Warren, as I say,
is a brilliant, he’s not only a good analyst, but he’s a very good
judge of businesses and he knows. I mean, my gosh, he buys a
company and the guy’s killing himself working for Warren. I would
have thought he’d retire. But Warren is a very good judge of peo-
ple and he’s a very good judge of businesses. And what Warren
does is ?ne. It’s just that we just really can’t do it that way. [He
?nds] ?ve businesses that he understands, and most of them are ?-
nancial businesses, and he’s very good at it. But you’ve got to
know your limitations.
QUESTIONS AND ANSWERS 263Q. Are you involved with commodities at all and if so—do you see
silver as undervalued?
W.S. You know, I have no opinion about any commodity or where
it’s going to go, and Asarco is a commodity company in copper. I
have no idea if copper can keep going lower. But I just think that
the stock is cheap based upon its price, not necessarily because I
know what’s going to happen to the price of copper any more
than silver. I have no opinion on any of those things. It saves me a
lot of time.
Q. Do you sell short?
W.S. We did it a couple of times and we’re always very upset after
we do it. So I’d say not anymore.
264 “65 YEARS ON WALL STREET”APPENDIX 5
Martin Whitman
on Value
Versus Growth
*
T
here is no dichotomy between value and growth. Indeed, most of
the common stocks in which Third Avenue Value Fund invests are
growth stocks.
There is a huge dichotomy, however, between value and generally
recognized growth. When people speak of growth, they really mean
generally recognized growth. That means buying what is popular
when it is most popular.
I’ve been asked frequently, Has value come back? That is the
wrong question. Rather the question should be, Have the gross spec-
ulative excesses that characterized the period from 1995 through the
?rst quarter of 2000 gone away?
Let’s look at how the garden variety of growth stock analysts ana-
lyze, and contrast that with what value analysts do.
Basically, growth stock analysts are outlook conscious and price
unconscious. Or, in any event, they assign more weight to forecasts
than they do to current prices.
265
*From a talk in January 2001 before the American Association of Individual In-
vestors, Northern New Jersey Chapter.Their outlook focuses on forecasting only future ?ows, whether
revenues, cash, or earnings. The balance sheet is ignored as “what is.”
They make bets on market forecasts—basically, top down. They
try to buy at bottoms and sell at tops.
They make market judgments rather than investment judgments.
They try to predict future prices.
Many are strictly market players. They try to predict the near-
term market, with a lot of focus on actual earnings versus consen-
sus forecasts.
This leads up to the growth stock trap. If you are wrong in any of
your forecasts—the economy, market, industry, company earnings—
market losses are huge and swift.
Indeed, very few growth stock analysts are really long-term con-
scious. They are interested only in short-term market movements.
The long-term outlook changes every day as the price of the Nasdaq
Composite changes.
If you want to be a growth stock investor to take advantage of
the public’s interest in grossly overpaying for mostly garbage, the
way to do it is to be a promoter—a ?rst-stage venture capitalist.
Seed private companies with capital, with intent to take them pub-
lic via IPOs.
What is right about growth-stock investing?
•It’s the only way to get near-term stock performance. Buy what
is popular when it is most popular.
•There is tremendous institutional pressure to keep the growth
market buoyant.
•They create corporate value by cheap access to the capital mar-
kets.
Value analysts are price conscious. They take a balanced ap-
proach. To them, price is at least as important as what is forecast.
They analyze businesses the way private businesses do, the way
takeover people do. The goal is to create corporate wealth over time.
There are many ways to create wealth: unrealized appreciation, as-
set redeployment, re?nancings, having operating earnings. (Though
operating earnings is the least desirable way of creating wealth be-
cause it is tax disadvantaged.)
There are four elements of how Third Avenue Value invests in
stocks—cheaply and safely.
1.The companies have overwhelming ?nancial strength as mea-
sured, ?rst, by an absence of debt (whether on the balance
sheet, in ?nancial-statement footnotes, or elsewhere); and
266 MARTIN WHITMAN ON VALUE VERSUS GROWTHsecond, by the existence of attractive assets, such as surplus
cash.
2.The companies are reasonably well managed. This is usually
the most dif?cult element for us to analyze. We conduct our
evaluation of a company from the point of view of passive, out-
side minority investors—investors with little or no hope of hav-
ing any in?uence over the way the company is run.
3.The company must have an understandable business. For us,
this means, at a minimum, that the company meets all SEC dis-
closure requirements and has issued audited ?nancial state-
ments. We think that these documents constitute not necessarily
the truth, but rather reliable and objective benchmarks.
4.The company’s common stock must be selling at a price no
greater than 50 percent of what we think it would be worth if
the business were a private company or a takeover candidate.
MARTIN WHITMAN ON VALUE VERSUS GROWTH 267APPENDIX 6
A Weekend with the
Wizard of Omaha:
April 2001
A
man from Oklahoma asked: “What’s going to happen when news-
papers run the headline ‘Buffett Kicks Bucket’?”
The question elicited gasps from the audience, but Warren E. Buf-
fett himself, age 70, chairman of Berkshire Hathaway and by com-
mon consent the world’s greatest investor, wasn’t fazed. “I think it
will be worded a little more elegantly,” he said dryly, but he thought
the question was legitimate.
He himself regularly asks the people who run the companies
owned by Berkshire Hathaway (like Benjamin Moore paint): If you
died today, what letter do you wish you had written for me to receive
tomorrow?
His answer to the question about his own demise: The company
ran nicely without him for a while when he left to become tempo-
rary chairman of Salomon Brothers in the early 1990s, and he’s
provided for succession via both an investment manager and an
administrator.
It was the annual meeting of Berkshire Hathaway in Omaha on
Saturday, by far the best-attended (12,000 shareholders) and longest-
running annual meeting (six hours) in the history of civilization, and
it was pure pleasure. Morning and afternoon you could listen to two
super-smart guys (Charlie Munger, 77, is vice chairman) talk about
268almost everything under the sun, talk enlivened by their quick and
perfectly delicious senses of humor.
An 11-year-old girl, a shareholder: “My father wants to know: Do
you have a grandson near my age?” (Laughter.)
Buffett: “How many shares do you own?”
A young man, a shareholder, stood up and said: “Last year, Mr.
Buffett, someone asked you to ‘juice up’ Berkshire Hathaway’s re-
turns by buying technology stocks.” (Pause.)
“Well, I’d like to thank you for paying no attention to him.” (Gen-
eral applause.)
Buffett, as is his habit, turned out to be right: Technology stocks
weren’t exactly a good buy in the year 2000. Munger, like Buffett, has
a keen, no-nonsense mind and a dry, sly sense of humor. He tossed
off at least one memorable line: “If you become rich quickly while
you’re young, thanks to passively investing in paper documents, and
that’s all you accomplish in life, you’re a failure.”
The two men have a high regard for each other, even though
Buffett kids Munger a lot. (At one point, Buffett said that Munger
would have a few words from Benjamin Franklin to quote, and
Munger seemed ticked off. Buffett sensed that, and said something
apologetic.)
Munger is laconic and sparing with compliments, but at one point
he said that Berkshire had bene?ted from Warren’s uncanny ability
to invest money shrewdly—and Buffett looked as pleased as a child
receiving a pat on the head from his teacher.
Some scenes from that weekend:
•Omaha isn’t bad at all. Wide streets, plenty of parking lots,
only rare traf?c jams. All-day parking at the nearby airport costs
$4. A lovely arti?cial stream is smack in the center of the city. A lot
of new construction, but also a lot of old dark-brick buildings,
some with quaint, early-twentieth-century ads printed on them.
Example: A particular medication will clean out “your liver, kid-
neys and bowels.”
•Buffett lives in a big, impressive house, but no better than other
houses in the area. A young blond security guard peers at me as a
cab drops me off. “Can I take pictures?” “From the sidewalk.” The
cab driver assures me that only during the annual meeting is there a
security guard at Buffett’s house. The of?ces of Berkshire Hathaway
are in a modern of?ce building a few minutes’ drive away, and
there’s no sign outside that says Berkshire Hathaway.
•Big disappointment. I wanted someone to take a photo of me
A WEEKEND WITH THE WIZARD OF OMAHA: APRIL 2001 269standing next to Buffett. Then the newspaper I work for would run
the photo with this caption: “Celebrated ?nancial writer Warren
Boroson with unidenti?ed Berkshire Hathaway shareholder.” No
luck.
•The Yellow BRK’ers are the leading Berkshire Hathaway fan
club; members have a message center on America Online. One of the
founders is a New Jersey fellow: John Gartmann, 67, of Delran in
Burlington County. The color yellow in their logos, he told me, is for
the Yellow Brick Road, which you must take to visit the Wizard of
Oz. (The stock symbol is BRK.)
Why did he invest in Berkshire? “I’m not the sharpest tool in the
shed, and when I see someone brilliant, like Buffett, I hang on to
him. He’s the master. He can do no wrong.”
Sherrie Gregory, who’s from Nebraska: “We love his philosophy
and his morals—his honesty, his fairness. We’re an old-fashioned
group.”
I asked Mohnish Pabrai, a money manager from Long Grove, Illi-
nois, whether owners of the expensive A shares are higher in the
pecking order than people like me, who own the cheaper B shares.
“The A share owners probably think they are,” he answered dryly.
Why was he wearing an especially gigantic yellow hat that said
“Yellow BRK’ers”? Buffett gives you that hat, he answered, if you
amass 100 A shares (worth $7,000,000). For a second I believed
him.
The doors in the huge civic auditorium opened at 7 A.M.When I
arrived at 7:20, I got a seat maybe 75 yards away from the stage—
like the uppermost seats, the family circle, at the Metropolitan
Opera. A woman sitting next to me was delighted at how “close”
her seat was. I stared at her. Shareholders came from all over the
country and even outside the United States. Some were New
Yorker types, elegant and spiffy; others were just ordinary folks.
Entire families were there—sisters, cousins, aunts. Almost every-
one was friendly and willing to chat. A slim, elegant blonde, an
older woman, inquired of a gentleman sitting near me whether an
unoccupied seat was taken. Yes, it was, she was told. She swore. I
giggled.
Someone walked around dressed as a brick (Berkshire owns a
brick company, Acme); someone else walked around as a Dairy
Queen cone. (Berkshire owns that, too.)
Buffett’s health is a big concern among shareholders. When Buf-
fett mentioned that he visited his physician once every ?ve years, an
270 A WEEKEND WITH THE WIZARD OF OMAHA: APRIL 2001elderly but remarkably well-preserved woman behind me, lunching
on healthy fruits and vegetables, said that that was “indefensible.”
Still, Buffett added that he was under no stress, and “I don’t smoke
or drink. And I’ll end it right there.”
A few young people asked for advice on investing, and at one
point Buffett said, “Stay away from credit cards. Read ?nancial pub-
lications. And save a few dollars.”
Which are the best business schools? Columbia, which has a
course on valuing securities, was mentioned, along with the Uni-
versity of Florida and Stanford. (Buffett and Munger are disdainful
of business schools that play up the Ef?cient Market Hypothesis,
the absurd notion that stocks are always reasonably priced.) “Fi-
nancial teaching, in general,” said Buffett, “is pathetic.” And later,
“If anyone ever starts talking to you about ‘beta,’ zip up your pock-
etbook.” (“Beta” is a measure of risk used by the Ef?cient Market
people.)
Why does Buffett drive such an old car? His has two air bags, he
answered, and if there were a safer car, he would drive it. But there
isn’t, he insisted, and he doesn’t want to spend time searching for a
new car and becoming familiar with it. Why did Berkshire drop
Fannie Mae and Freddie Mac? Because, the two men answered, the
companies are taking on extra risk. How often do they get great
ideas? Once every two years. “And,” said Buffett, “there should be
a few more before we’re done.” On companies that lose their edge:
Kellogg’s raised its prices too high; Campbell soup suffered be-
cause people’s tastes changed. On selling short (betting on stocks
going down): “It’s ruined a lot of people,” Buffett said. “Losses can
be unlimited. But we see many more overvalued stocks than under-
valued stocks.”
Shareholders had a weekend of activities laid out for them, includ-
ing watching Warren himself throw out the ?rst pitch at a minor
league baseball game, then bat against former big league pitcher
Bob Gibson. Buffett hit a miserable, pitiful, feeble little roller to the
mound. His charming secretary, Debbie Bosanek, later said she was
amazed that he accomplished that much. (And still later, she re-
buked me for having written what I did because, she explained, it
lowered the chances that Sports Illustrated would cover next year’s
baseball game.)
Shareholders idolize Warren and Charlie, not just because Berkshire
Hathaway boasts such a splendid record, but because they’re obvi-
ously such wise and honorable gentlemen.
A WEEKEND WITH THE WIZARD OF OMAHA: APRIL 2001 271At a press conference on Sunday, guess who got to ask the ?rst ques-
tion? “Three well-known mutual funds,” I said, “invest similarly to
Berkshire: Sequoia, Clipper, and Tweedy, Browne. Which seems to
adhere the most closely to your strategy?”
All are similar, Buffett replied, but all have certain differences,
too. And the late Phil Carret, who ran the Pioneer Fund, Buffett con-
tinued, also invested in stocks the way Buffett has learned to. (See
Appendix 7.)
An amusing ?lm preceded the shareholders’ meeting. Buffett gave
a golf lesson to Tiger Woods, telling him that his right arm was
too much in play. Woods apparently heeded his advice and hit
a wicked shot; said Buffett, impressed by Woods’ stroke, “You
learn fast.”
Woods did some juggling tricks with his golf club and golf balls;
throughout the remainder of the ?lm, Buffett tried to do the
same—eventually succeeding, thanks in no small part to trick
photography.
Judge Judy adjudicated a dispute between Buffett and Bill Gates
over who had won a bridge game and who owed whom money. She
mispronounced Buffett’s name, but decided that he had won and
Gates had lost. “Pay him the two dollars and make something of
yourself,” she told Gates severely.
Ben Graham Productions presented a short ?lm on “Citizen Buf-
fett,” reviewing his life.
Buffett and some very rich Omaha friends appeared on “Who
Wants to Be a Millionaire?” with Regis Philbin. When Philbin asked,
“Who wants to be a millionaire?” the three multimillionaires walked
off in disgust.
After returning, Buffett won a lot of money and announced that he
would give each of his kids $300 (he’s notoriously cheap), and buy a
second suit and a comb.
Back to the meeting: Why had Buffett regretted not buying phar-
maceuticals years ago, but still avoided technology? Munger’s an-
swer: It was much more obvious that pharmaceuticals in general
would do well.
What mistakes had they made? Mainly errors of omission—not
buying good stocks. “We’ve blown billions and billions of dollars,”
said Buffett. “And we’re getting better at it.”
Might some of Berkshire’s holdings, like Dairy Queen and Coca-
Cola, get into trouble for not being thought healthy? Buffett was re-
assuring: He has been living on such foods for 70 years.
272 A WEEKEND WITH THE WIZARD OF OMAHA: APRIL 2001David Winters of Mountain Lakes, New Jersey, inquired about
Berkshire’s advantages, and Buffett talked about the company’s
not being under any pressure to do anything. On the other hand,
he added, the company’s huge size was a handicap: Berkshire,
with all its cash, must take huge positions. Winters, it turned out,
is chief investment of?cer for the Mutual Series Fund in Short
Hills, New Jersey.
In an elevator later on, I heard a young woman say to her husband,
“The two of them are so cute!”
A WEEKEND WITH THE WIZARD OF OMAHA: APRIL 2001 273APPENDIX 7
“If You Own a Good
Stock, Sit on It”
—Phil Carret
When I asked Warren Buffett (at a recent press conference in
Omaha) which mutual funds employed investment styles simi-
lar to his, he replied that the three funds that I myself had
named—Sequoia, Clipper, and Tweedy, Browne—were similar ...
and dissimilar.
He then mentioned that when he was in his 20s he had been im-
pressed by Phil Carret, who had started the Pioneer Fund in 1928,
and had met him and learned a good deal from him. By coincidence,
I interviewed Carret a few years before he died, in 1998, at age 101.
He was an easygoing, unpretentious gentleman with a logical, no-
nonsense mind.
I had ?rst run into him around 1990, when he and two other giants
of the investment world, Max Heine of the Mutual Series Fund and
Julian Lerner of the AIM funds, took part in a memorable discussion.
The panel had been set up by Bill Lippmann, who now runs a few
Franklin funds. What impressed everyone about that discussion was
how much all three money managers loved investing—Carret in par-
ticular. And how differently the three men invested—yet with simi-
lar, most excellent results. As Max Heine, an urbane, witty
gentleman, said at the conference’s conclusion, “All roads lead to
Jerusalem.”
274Carret had an unusual hobby: viewing eclipses from around the
world. As I recall, he had seen around 50. He was also one of the few
investors who had lost money in both 1929 and 1987.
Here are excerpts from my 1994 interview with Carret at his of?ce
in New York City:
Questions and Answers
Q. Is it true that you in?uenced Warren Buffett?
P.C. I don’t in?uence Warren. He in?uences me. I sent him a
telegram the other day when his stock hit $20,000. I wrote: $20,000
WOW CONGRATULATIONS. [The stock is now around $70,000 a
share.]
Q. Are you worried about how popular mutual funds have be-
come?
P.C. No, I think mutual funds are ideal for the average citizen who
doesn’t want to bother to or doesn’t have the necessary equipment
to make judgments on his own. But they should understand that
they will not make a lot of money out of it. Ten dollars will grow to
$12 or $15, not to $150.
Q. Did you foresee the amazing popularity of mutual funds?
P.C. (laughs) No. I can remember thinking that if the Pioneer Fund
ever got to $25 million I really would have arrived. Now, with $25
million you couldn’t possibly cover even the overhead.
Q. How do you feel about investing abroad?
P.C. There are great companies abroad, but they keep books dif-
ferently—or they used to. I had a good friend, and I told him I
didn’t understand foreign bookkeeping. Why do they keep three
sets of books? He said that one was for the stockbrokers, one for
management, and one for the real insiders. But I think things
have changed, and now they keep the books in an up-to-date
fashion. We get questions all the time, why not 5 percent abroad?
But if we buy Coca-Cola, at least 60 percent of its revenue comes
from abroad. We don’t buy it. I don’t like the drink.
Q. Don’t let Warren hear you say that.
P.C. But I own some Berkshire Hathaway, so indirectly I own some
Coca-Cola. For the small investor, I might recommend maybe 10
percent in foreign stocks. But if one is an American, brought up
QUESTIONS AND ANSWERS 275here, you understand the way things are done—it’s much simpler
to invest here instead of trying to ?gure out the mental processes
of Amsterdam or Zurich. Our clients feel more comfortable with
American companies rather than if you go ?shing around the
world.
Q. Like Buffett, you buy and hold, don’t you? Your strategy is simi-
lar to Buffett’s?
Pioneer Executive: Maybe Buffett’s strategy is similar to Phil’s.
P.C. Warren is obviously much smarter than I am. I’ve known War-
ren for probably 40 years, and if I phoned, he would take the call.
But I don’t bother him.
Q. How often are you right about the direction of the stock market?
P.C. Ten percent. Unfortunately, the contrary opinion school has a
great deal of validity. When everyone is bullish, why, you should
be very concerned. I was in Rome in 1987 when the market fell out
of bed and lost 500 points in one day, and I still don’t know why it
happened. I hadn’t foreseen anything. But I didn’t owe anyone any
money—I never do.
Q. Buffett has commented that you went through both the crash of
1929 and the crash of 1987. Were they similar?
P.C. [The crash of] 1929 was much worse. If it had stopped by Jan-
uary 1930, it would not have been so bad. But it was kind of excit-
ing, you know. Those on margin in a big way were of course
devastated.
Q. Do you market-time at all?
P.C. No. If you’re doing the right things, a bear market is not going
to kill you. And you should be philosophical. If the market is down
50 percent and your account goes down only 40 percent, why,
that’s a great triumph.
Q. Do you favor investing gradually in a stock—dollar-cost averag-
ing?
P.C. If you ?nd something attractive, buy it.
Q. In evaluating a company, how important is management?
P.C. Management is the important factor in a company. Anyone
who gets to be chairman or president of a company is a fairly
smooth operator, and talks a good ?ght, you know. You have to
look at his record—how much of his own money is in the stock
276 “IF YOU OWN A GOOD STOCK, SIT ON IT”—PHIL CARRET(my yardstick is a year’s salary)—and is he wildly optimistic or
cautious? If he says things are pretty good and the results were
very good, that’s great. If he says things are ?ne and there’s a lousy
quarter, I don’t want his stock.
Q. When do you sell?
P.C. I never sell anything, by and large, unless somebody takes it
away from me. If you have a good stock, sit on it. Unless you ?nd
something that’s obviously much better, cheaper.
Q. I understand that you believe that doctors are terrible investors,
and you have turned down doctors as clients.
P.C. If a doctor doesn’t believe his diagnosis and his prescrip-
tion, he shouldn’t be in the profession. He has to believe that
he’s almost God. And many of them carry this over and tell you
how to invest.
Q. Have you heard the worrisome talk that Social Security may run
out of money soon? It might have to be eliminated, or a means test
set up.
P.C. I’ll be gone. I’ll let you worry about it.
Q. You knew Dean Witter? You knew Clarence Barron, who owned
the Wall Street Journal?
P.C. Dean Witter was very sharp. Barron weighed 300 pounds, and
was handsome from here up, with his white beard. They said that
he hadn’t seen his feet for 40 years.
Q. How many stocks do you need, as a minimum, to be diversi?ed?
P.C. For an individual, 25, I think.
Q. How many securities can one person follow?
P.C. I knew a brilliant man named Fred, and he was asked whether
his fund should really own hundreds of different securities. “I own
400 or 500,” Fred said, “and I can’t watch them all. But if you buy
them cheap enough, they watch themselves.”
Q. Who is that on your coffee cup?
P.C. Ludwig van Mises, the greatest economist of the twentieth
century, in my judgment. He was a founder of the Austrian eco-
nomics movement, which has never taken off—compared with
Lord Keynes, and I regard Keynes as disastrous for all concerned.
Van Mises was in favor of free enterprise—and so am I. There’s
nothing like competition.
QUESTIONS AND ANSWERS 277Q. Have you ever read Peter Lynch’s books?
P.C. I’ve glanced through them.
Q. Lynch visited Buffett once, and Buffett said of him, “A very
clever young man.” I ?gured that what that meant was “I could
have him for breakfast.” (general laughter)
Q. What are the worst mistakes investors make?
P.C. The stupid thing we all do is to get more and more bullish as
the market goes up—and be frightened out of our wits when it
goes down.
Q. How do you stay in such great health?
P.C. I carefully avoid exercise. I eat what I like. And I enjoy my
work. But the greatest success of my life was my wife. I enjoyed
63 years of perfection. I used to tell her that she was 99.99 percent
perfect. But I really thought she was 100 percent.
278 “IF YOU OWN A GOOD STOCK, SIT ON IT”—PHIL CARRETGlossary
Actively managed mutual fund A mutual fund whose managers buy securities
intending to do better than the average, represented by an index of that market. Op-
posite of a passively managed index fund.
Annuity A tax-deferred investment offered by an insurance company. When you
receive an annuity, you receive payments in equal installments for a speci?ed period
of time.
Arbitrage Selling one security in one market and buying it in another market, or
vice versa, to take advantage of price disparity.
Asset allocation How your money is spread across different types of invest-
ments, like stocks, bonds, and cash equivalents.
Balance sheet A statement of a company’s assets and liabilities at a certain time.
Bear market A period when securities have become relatively low-priced. With
stocks, a decline of 20% or more is considered a bear market. A decline of 10% to
20%, a correction.
Beta A measure of volatility that compares a security’s volatility with the volatility
of an index of the same securities. The market, or an index of the market, is as-
signed a beta of 1.00; a stock or a fund with a beta of 1.25 might be 25% more
volatile.
Bond A ?xed-income investment that typically pays the lender regular interest,
and promises to repay the lender the principal after a speci?ed period of time (“ma-
turity”).
Book value A company’s total assets minus liabilities minus stock issues that are
ahead of common stock (like preferred stock) in case the company is liquidated and
279shareholders are compensated. Book value can be more, or less, than market
value—the price of the stock times the number of shares outstanding.
Bull market A period when security prices have soared.
Capital gains (losses) Pro?ts or losses on an investment.
Capitalization The total value of all the securities—stocks, bonds—issued by a
corporation.
Capitalization weighted Said of an index like the Standard & Poor’s Index,
where the power given to individual stocks depends on their capitalization.
Cash ?ow A company’s income, after taxes, plus expenses that have to be paid—
depreciation expenses, amortization expenses, and so forth.
Closed-end investment company A mutual fund whose shares are bought and
sold on an exchange or over-the-counter by investors trading among themselves.
Only a limited number of shares are issued. Managers of closed-end funds need not
sell; shareholders buy and sell among themselves.
Common stock A unit of ownership of a company. Owners of preferred stock
have ?rst dibs in getting their money back in case of bankruptcy.
Contrarian An investor who bucks the majority opinion, perhaps buying stocks
or a stock when most people are selling, for example, or selling when most people
are buying. Contrarians are a species of value investor.
Current asset Cash, or whatever can be converted into cash, within one year.
Current ratio A company’s assets divided by its liabilities. A measure of how
readily a corporation can pay its debts from its assets.
Data mining Checking information to ?nd patterns.
Discount When a security sells for less than its face value.
Diversi?cation Investing in a variety of different securities and assets, to guard
against one’s entire portfolio bottoming at one time.
Dividend A distribution of earnings to shareholders.
Dollar cost averaging Investing a set amount into securities at a set period of
time, not all at once. Purpose: to buy more shares when prices are low, fewer when
prices are high.
Dow Jones Industrial Average A popular measure of stock market perfor-
mance.
Ef?cient Market Theory The notion that market prices re?ect the full knowl-
edge and expectations of all investors, so that it is impossible for investors to out-
perform the market unless they take more risk. (See Nutty Investment Theory.)
Float Someone’s ability to use money for a time before having to give it to some-
one else.
GARP Growth at a reasonable price. A strategy of growth investors, attempting to
buy growing companies but not overpaying.
Goodwill Valuable and important attributes of a company, but hard to measure,
such as its brand-name recognition, its reputation for integrity, the excellence of its
personnel, its penetration of its markets. It’s the difference between the value of the
assets a company owns (buildings) and what a reasonable buyer might pay for the
entire company. Also called “intangibles.”
Growth strategy Investing in healthy companies, with relatively high price-earn-
280 GLOSSARYings ratios and high price-book ratios. Growth stocks tend to do well at different pe-
riods of times from value stocks. Certain industries, like health care and technology,
tend to be composed of growth stocks. Growth portfolios tend to have higher
turnovers than value portfolios. Growth stocks are sometimes called “glamour
stocks.” A growth strategy may be “momentum” or “GARP.”
Holding company A corporation that owns stock and manages other corpora-
tions.
Index Selected stocks or bonds that are meant to mirror an entire investment
market.
Index fund A fund whose performance is tied to a speci?c market index, such as
the Standard & Poor’s 500 Stock Index.
Initial public offering (IPO) The ?rst sale of a new stock or bond.
Intrinsic value The essential value of a stock. If you package 10 stocks together
in one unit, like a closed-end fund, and sell that unit, and someone buys it for less
than the individual stocks are worth, the unit is selling at a discount to its intrinsic
value. The intrinsic value of a stock is dif?cult to measure, but clues are its potential
to continue to produce pro?ts and what reasonable buyers have paid for similar
companies.
Leverage Buying stocks or other securities by borrowing money.
Liquidity The ease with which an asset can be turned into cash without loss.
Margin of safety In security analysis, buying a security for signi?cantly less than
its intrinsic value, just to protect the buyer in case of unexpected problems.
Market value The price that an investment instrument can fetch on the open ?nan-
cial markets.
Momentum investing Buying stocks whose prices have recently been climbing.
Multiple Price-earnings ratio.
Nifty Fifty Fifty or so stocks that during the early 1970s were considered sure
winners; “one-decision” stocks. They crashed in 1973–1974.
Nutty Investor Theory The notion that market prices re?ect neurotic human
emotions, particularly the tendency to overvalue stocks when their prices have
climbed and to undervalue stocks when their prices have declined.
Operating earnings The difference between a corporation’s revenues, and its ex-
penses.
Passively managed mutual fund A mutual fund that mirrors an index.
Preferred stock A class of stock that gives the owner a higher claim to dividends
and to assets in the event of the company’s liquidation.
Present value The value today of a future dollar amount after it has been dis-
counted for interest that you did not receive.
Price to book ratio The share price of a stock divided by its net worth (book
value) per share. An indicator of whether a stock is expensive or not.
Price to earnings ratio The amount that investors are willing to pay for $1 of
earnings per share. Commonly, the earnings are for the past year. The higher the p-e
ratio, by and large, the more optimistic investors are about a stock’s growth—ex-
cept that the p-e ratios of stocks whose earnings have fallen recently may remain
high.
GLOSSARY 281Qualitative analysis Assessing a stock by focusing on nonmeasurable factors,
such as the quality of management, excellence of the product or service, resis-
tance to competition, brand-name recognition.
Quantitative analysis A way to evaluate a company’s stock using numbers; con-
trasted with qualitative analysis.
Quick ratio Cash, receivables, and marketable securities divided by liabilities; a
measure of liquidity.
R-squared How much the changes in one factor (variable) are explained by the
changes in another factor. Called coef?cient of determination. It ranges from 1 (per-
cent congruence) to 0 (no connection).
Return on equity Amount earned on a corporation’s common stock investments
over a certain time period. The percentage indicates how well shareholders’ money
is being used.
Risk The chances of losing value, or not gaining value. Different kinds of risks in-
clude market risk, economic risk, and in?ation risk.
Security A stock, bond, or other investment instrument.
Security and Exchange Commission The federal agency that administers the
laws regulating the securities industry.
Selling short Selling securities that you may have borrowed, intending to pay for
them when (you hope) their prices have gone down. A way to make money on secu-
rities whose prices seem poised to decline.
Standard & Poor’s 500 Stock Price Index An index of 500 stocks, mostly large-
company stocks traded on the New York Stock Exchange.
Standard deviation The volatility of an investment, measured by comparing its
average price with the degree of its ups and downs over three years.
Tangible book value Book value that does not consider good will, which is dif?-
cult to evaluate.
10K A report that the Securities and Exchange Commission requires of most com-
panies. It is more detailed than the annual report.
Total return The interest from bonds, dividends from stocks, and capital gains
and losses that a security receives in a speci?c period of time.
Turnover Trading activity—the frequency with which new securities are bought
and old ones sold.
Value strategy Buying stocks that seem to be cheap, based on their price-earn-
ings ratios and price-book ratios. Value stocks may be those of companies in trou-
ble, or companies that don’t promise to growth rapidly, such as utilities. Value
stocks tend to excel or decline at different periods from growth stocks. Value
stocks tend to have higher dividends than growth stocks, and value stock portfolios
tend to have lower turnovers.
Volatility The degree to which a security’s price bobs up and down.
Working capital The amount that current assets exceed current liabilities.
Yield The income that a security pays out in a year, as a percentage of the secu-
rity’s price.
282 GLOSSARYIndex