Wednesday, May 30, 2007

Thinking Like Buffett

It’s safe to say that Warren Buffett doesn’t spend much time thinking about how much the market went up or down this week. In fact, listening to him and reading his annual letters, it’s safe to say he couldn’t care less.

Buffett’s investment focus is on the quality of earnings, internal rates of return and relative valuations of the companies Berkshire Hathaway owns outright, and the common stocks of companies they own (or intend to own) within the insurance portfolios of Geico, General Reinsurance, and the several other insurance entities within the company. If you look at his shareholder letters (, he never reports how Berkshire Hathaway stock performed against the S&P 500 Index. Rather, he reports the percentage change in the internal per share book value of Berkshire (i.e., the company’s net worth divided by the number of shares outstanding) vs. the percentage change in the S&P 500. Based on that measure, you can count on one hand the number of years since 1965 that Berkshire didn’t outperform the market. And isn’t that the best way to look at yourself? In other words, how am I doing internally, not how does the market value my stock this month or this year? Ultimately, in the long term, the market always values internal rates of return, the real measure of shareholder economic value added; seldom, however, does it do so in the short term.

For example, Berkshire (BRKA/BRKB) is actually down a fraction of one percent year-to-date in 2007, while the S&P 500 is up about 7% and setting new records. In 2006, it was up about 22.5% vs. about 12% for the S&P, while in 2005 it was up only a bit more than 2%, vs. about 6% for the S&P. However, looking at one of our favorite market statistics, the performance of the S&P 500 from the beginning of 2001 (i.e., just before 9/11) through May 2007, you can clearly see Berkshire’s long-term market performance. During that 6.3 year period, BRKA has produced a compound annual yield of 7.9%, while the S&P 500 has produced (believe it or not) only 2.7% compounded. If you believe, as we do, that history has a fairly high probability of repeating itself over the next five or six years, thinking like Buffett is a pretty good idea.

Interestingly, about five or six years ago, Buffett was quoted in “Fortune” saying that he expected the market to increase only about “6% to7% annually over the next decade or two”. His own performance has obviously been better than that, but the S&P 500 hasn’t done as well as he predicted, so far.

Another “Buffettism” worth noting is the statement of his two rules of investing: “Rule #1, never lose money; Rule #2, never forget rule #1”.
Not a bad way of thinking in our book!

We strive every day to think like Buffett, as opposed to the short-term market-think and hype with which we are all besieged. We know for sure that companies that generate strong internal rates of return create economic value added for their owners. We also know for sure that good companies that are overvalued by the market in the short term are not good long-term investments, regardless of how exciting they may look. There will always be a better time to own them if we are patient. This is why valuation modeling is so important to us.

While we do not imitate Buffett’s investment decisions, we do take note of what he does, because he does much the same kind of valuation analysis we do. Not surprisingly, we own several of the same companies. Here are some examples:

Berkshire Hathaway (BRKA, BRKB)
In most of our portfolios, BRKB, Berkshire’s non-voting “B” stock is one of our largest holdings, representing about 8% of our equity portfolios. In addition to its publicly traded common stock holdings, Berkshire owns a number of companies outright, such as Dairy Queen and MidAmerican Energy, which includes Home Services (Edina Realty). Also, Berkshire is able to do things with its large cash position, which most investment managers can’t even imagine, including taking large hedge positions vis-à-vis the weakening U. S. dollar.

Conoco Philips (COP)
Berkshire owns 1.1% of Conoco’s outstanding shares. We bought our COP on the basis of its ROI and valuation at about the same time as Buffett. It currently represents about 5% of our portfolios and has done very well for both Berkshire and ourselves.

Moody’s (MCO)
Berkshire owns a whopping 17% of MCO, acquired when it went public. We acquired our position much later on the basis of MCO’s extraordinary ROI and low valuation. It has grown 116% to approximately 8.5% of our holdings. See our March 23, 2006, blog posting “Happy to be Moody”.

Johnson & Johnson (JNJ)
Berkshire owns about .7% of JNJ stock and we believe we acquired most of our position ahead of them. JNJ represents about 5.5% of our holdings. It has been a slow mover over the past year, but is one of the strongest pharmaceutical and over-the-counter healthcare product providers in the world, with excellent ROI and valuation.

Wal-Mart (WMT)
Berkshire owns .5% of WMT. It currently represents about 3% of our holdings and has not been a good performer for either Berkshire or ourselves. It’s ROI and valuation fundamentals, however, are excellent.

Procter & Gamble (PG)
Berkshire is PG’s largest shareholder, with 3.2% of outstanding shares, as the result of both market purchases and PG’s acquisition of Gillette, which was one of Berkshire’s largest holdings. PG represents nearly 5% of our holdings. While it has been a slow mover over the last year, it is considered to be one of the strongest companies in the world.

US Bancorp (USB)
Berkshire reported owning 1.8% of USB’s stock in their 2006 annual report, but they have recently increased their position. We have owned USB for several years and have recently increased our position to a bit more than 5% of our holdings. Both we and Buffett apparently like their excellent ROI and the 4.7% dividend.

WellPoint Health Networks (WLP)
Berkshire is currently accumulating a position in WLP and has not as yet reported the size of their holding. WLP, which is the largest Blue Cross/Blue Shield insurer, currently represents about 4.5% of our holdings and is one of our favorites. We began acquiring positions in WLP and Aetna (AET), after taking a significant profit in United Health Care (UNH), which Buffett still holds. Both WLP and AET continue to do very well for us.

Including BRKB, approximately 45% of our portfolio holdings are also held by Buffett, so we are obviously thinking alike and doing many of the same things. While we don’t agree with all of Berkshire’s investments and believe that some of our holdings are better than theirs (for example, they own 8.6% of Coca Cola, which has been a very poor performer over the last 10 years), we strongly agree with Buffett about holding value-creating companies with proper valuations.

Most importantly, when one “thinks like Buffett”, the day-to-day ups and downs and new records of the market become largely irrelevant to the central mission of creating compounding long-term returns.

As always, we welcome your thoughts and ideas.

Jack and Peter Falker

Note: Both Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in the companies mentioned in this article, with the exception of United Healthcare.