How to think like Benjamin Graham and invester like Warren Buffett

HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT This page intentionally left blank. HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT Lawrence A. Cunningham McGraw-Hill New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2001 by the McGraw-Hill Companies,Inc. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-138104-X The material in this eBook also appears in the print version of this title: 0-07-136992-9. All trademarks are trademarks of their respective owners. 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DOI: 10.1036/007138104X abc McGraw-Hill vCONTENTS Acknowledgements ix Introduction: The Q Culture xi PART I: A TALE OF TWO MARKETS 1 Chapter 1. Mr. Market’s Bipolar Disorder 3 Swings, Bubbles, and Crashes / 5 Be an Anomaly / 11 Barrel of Monkeys? / 12 Chapter 2. Prozac Market 17 Obscurity / 17 Simplicity / 18 The Perfect Dream / 22 Tidying Up the Tale / 28 Chapter 3. Chaotic Market 33 New Wave / 33 Next Wave / 36 Complexity / 46 Behavioral Finance / 47 Chapter 4. Amplified Volatility 51 Information Volatility / 51 Transaction Volatility / 59 Trader Volatility / 63 Prognosis / 66 Chapter 5. Take the Fifth 69 Who’s in Charge? / 70 Sticking to Your Knitting / 71 Alchemy / 81 The Long Run / 86 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use vi Contents PART II: SHOW ME THE MONEY 89 Chapter 6. Apple Trees and Experience 91 Fools and Wisdom / 91 Horse Sense / 100 Chapter 7. Your Circle of Competence 105 The Initial Circle / 106 The Nurtured Circle / 109 A Full Circle / 114 Decision Making / 116 Chapter 8. Recognizing Success 119 Business Fuel / 120 Managers under the Microscope / 124 Bang for the Buck / 128 The Full Tool Chest / 131 Chapter 9. You Make the Call 133 Assets / 134 Earnings / 138 Silver Bullets and the Margin of Safety / 142 Cash / 144 Market Circularity / 146 Chapter 10. Making (Up) Numbers 153 Perennials / 153 Satire / 157 Charades / 162 Coda / 167 PART III: IN MANAGERS WE TRUST 169 Chapter 11. Going Global 171 The Two-World Story / 172 Illusions of Duty / 176 One World to Come / 180 Contents vii Chapter 12. Rules and Trust 193 The Family Manager / 193 Local Governance / 195 General Governance / 200 Your Voice at the Table / 202 Chapter 13. Directors at Work 205 Hail to the Chief / 206 Pay / 207 Deals / 212 Capital / 215 Checking Up / 217 Chapter 14. The Fireside CEO 221 Master Servants / 221 Action / 222 Lights / 230 Trust / 235 Conclusion: The V Culture 243 Notes 245 Index 257 This page intentionally left blank. ix ACKNOWLEDGMENTS The main ideas in this book trace their intellectual lineage toBenjamin Graham, whom I never knew but must thank post- humously, and Warren Buffett, whom I have the great fortune to know and from whose writings, talks, and conversations I have gained knowledge and insight. Neither of these men, of course, has any responsibility for this book’s content and no doubt would disa- gree with some of what it says, though it is written as a narrative interpretation of principles they developed, to which it tries to be faithful. Mr. Buffett deserves my continuing thanks for permitting me to prepare a collection of his letters to the shareholders of Berkshire Hathaway, The Essays of Warren Buffett: Lessons for Corporate Amer- ica, and for participating along with Berkshire Vice-Chairman Charles Munger in a symposium I organized to analyze it. Thanks also to the readers of that collection of wonderful writings for en- couraging me to write the present book, especially the courageous college and business school professors who use that book in their courses and their many students who tell me how valuable it is. Other fans of that book who encouraged me to write this one include my friends at Morgan Stanley Dean Witter, led by David Darst and John Snyder; Chris Davis and KimMarie Zamot at Davis Selected Advisers; the team at Edward D. Jones; and supporters too numerous to mention at other firms who appreciate the business analysis way of investing. By training and professional habit I am a corporate lawyer, and as my students know, effectiveness as a corporate lawyer requires mastering not only (or mostly) law but also business, including fi- nance, accounting, and governance. For tutelage in that philosophy, I thank my friends and former colleagues at Cravath, Swaine & Moore as well as that firm’s clients. Not all law faculties recognize the intersection of law and busi- ness. My colleagues at Cardozo Law School do and support my re- Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use x Acknowledgments search and writing in the fields of finance, accounting, and gover- nance that seem to others a step beyond law as such. Among these colleagues, special thanks to Monroe Price for introducing me to Warren Buffett through their mutual friend Bob Denham. For grant- ing me a sabbatical to devote time to work on this book, I especially thank Dean Paul Verkuil and Dean Michael Herz. My personal and institutional ability to span these and other subjects has been greatly aided by Samuel and Ronnie Heyman, both nonpracticing lawyers and astoundingly talented businesspeople, in- vestors, and philanthropists. They generously endowed the Samuel and Ronnie Heyman Center on Corporate Governance at Cardozo, a multifaceted program I direct that explores this range of disciplines in teaching, research, and policy review. My own teachers also deserve my thanks, particularly Elliott Weiss, now professor at the University of Arizona College of Law, who long ago drew my attention to Graham and Buffett’s ideas and who generously shares his wealth of knowledge. For allowing me to use in modified form some materials from a textbook we worked on together. I also thank Professor Jeffrey D. Bauman of Georgetown University Law Center, and West Group, that book’s publisher. Thanks also to West Group for allowing me to use in modified form some materials from another textbook I wrote, Introductory Account- ing and Finance for Lawyers, which is not for lawyers only. Many thanks to the whole team at McGraw-Hill for their con- fidence, enthusiasm, and guidance, particularly Kelli Christiansen, Jeffrey Krames and Scott Amerman. Most of all, thanks to my wife, JoAnna Cunningham, who pains- takingly edited the entire manuscript with precision and grace and encouraged me every step of the way. xi INTRODUCTION: THE Q CULTURE Common sense is the heart of investing and business manage-ment. Yet the paradox of common sense is that it is so uncom- mon. For example, people often refer to a stock or the market level as either “overvalued” or “undervalued.” That is an empty statement. A share of stock or the aggregate of all shares in a market index have an intrinsic value. It is the sum of all future cash flows the share or the index will generate in the future, discounted to present value. Estimating that amount of cash flow and its present value are difficult. But that defines value, and it is the same without regard to what people hope or guess it is. The result of the hoping and guessing game—sometimes the product of analysis, often not—is the share price or market level. Thus, it is more accurate to refer to a stock or a market index as overpriced or underpriced than as over- valued or undervalued. The insight that prices vary differently from underlying values is common sense, but it defies prevalent sense. Think about the ticker symbol for the popular Nasdaq 100: QQQ. The marketing geniuses at the National Association of Securities Dealers may have chosen three Qs because Q is a cool and brandable letter (think Q-Tips). In choosing from the letters N, A, S, D, and Q, however, they se- lected the one (three times) that stands for Quotation and unwit- tingly reflect a quote-driven culture by this quintessentially New Economy index created in mid-1999. Quotes of prices command constant attention in the mad, mod- ern market where buyers and sellers of stocks have no idea of the businesses behind the paper they swap but precisely what the price is. Quote obsession trades analysis for attitude, minds for myopic momentum, intelligence for instinct. Quotations are the quotidian diet of the day trader, forging a casino culture where quickness of action fed by irrational impulses displaces both quality and quantity Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use xii Introduction: The Q Culture of thought. QQQ is an apt symbol for the most volatile index in stock market history. In the Q culture, common sense is common nonsense, putting price on a pedestal and all but ignoring business value. The Q trader sees price as everything. The smart investor knows what value is. She focuses on value first, and then compares value to price to see if an investment holds the promise of a good return. That kind of focus requires the investor to operate as a business analyst, not as a market analyst or securities analyst and certainly not as a Q trader. This book develops a mind-set for business analysis as the an- tidote to the Q culture. It discusses the tools of stock picking and highlights critical areas of thinking about markets and prices, and businesses and managers. It builds a latticework of common sense to fill the vast value void in today’s markets. The book first shows you why it is a mistake to operate as a market analyst or to look to the market to reveal value when all it can do is reveal prices. It then presents the tools to think about performance and value but also cautions about how financial infor- mation can be distorted in ways that can mislead you. Accordingly, it argues that an essential element of intelligent investing is a com- monsense ability to assess the trustworthiness of corporate manag- ers, principally the chief executive officer and board of directors. The business analysis approach to investing shatters many myths of investment lore prevalent in the Q culture though not unique to it throughout history. For example, it rejects a distinction as perva- sive as it is mistaken between growth investing and value investing (or between growth stocks and value stocks). To be sure, some com- panies show greater promise of earnings growth than others, but all rates of growth are a component of value so this distinction, crys- talized in the early 1970s and a growing fixation ever since, is of no analytical value. For another, the business analysis approach underscores a key distinction between investing on the one hand and speculation or gambling on the other. All investing involves risk and in that sense there is a speculative element in all of it. Intelligent investing, how- ever, calls for a reasonably ascertainable valuation and comparison to the price. Leading examples of speculating and gambling include people buying shares in IPOs or Internet start-ups they know little or noth- Introduction: The Q Culture xiii ing about and buying shares in any business without first reading its annual report or knowing what to look for in it. For every gambling success story you hear about, there are scores of failures you don’t. As The Wall Street Journal recently quipped, no brother-in-law has ever been known to reveal how much money he lost in the stock market. The focus on business analysis as opposed to market analysis is reinforced by the imaginary Mr. Market, created by the twentieth century’s most astute investment thinker and business school teacher, Benjamin Graham. Price and value diverge in capital market trading because the market is best characterized as manic depressive, mostly either too euphoric or too gloomy. This is contrary to the popular but mistaken belief that markets are efficient and therefore accurately price securities. Once you as a business analyst know how to look, the next ques- tion is where to look. The core idea is your circle of competence, created by the twentieth century’s most successful investor and busi- ness educator, Warren Buffett. It is defined by your ability to un- derstand a company’s products and operating context. Circles of competence are as varied as the investors who must define them. All investors must grapple with the challenge of using current and past information to gauge future business performance. For most people, it is easier to do this with businesses that have been around a long time, been through lots of business cycles, and faced economic recessions. Within that group of business are many whose long track records justify being called classics—well- established companies with powerful global products and market po- sitions like Procter & Gamble, GE, Coca-Cola, and Disney. Some of these will endure as stalwarts, while others will be beaten down (as GE did to Westinghouse or as Wal-Mart did to Sears Roebuck). The ability to tell which is which will vary among people with different aptitudes in evaluating these companies, for different sets of skills are necessary to understand these various sorts of businesses. So too will abilities vary with respect to assessing the future per- formance of newer companies that have been through fewer varia- tions in their operating climate. These are “vintage businesses”— those that have been around for a while but which operate in newer and more dynamic industries that evolve at a rapid pace—companies like Cisco, Intel, or Microsoft, for example. They have less of a track record, and may be harder for lots of people to understand. But some xiv Introduction: The Q Culture people will have the ability to understand them quite well and be able to make informed judgments about their future prospects. As with the classics, some vintage companies will turn out to be warriors and others wimps. For example, take the personal computer business. From 1990 to 1999 the erstwhile start-up Dell built a hugely profitable direct-sales PC business, growing its sales and prof- its at astonishing rates, with Compaq following respectably, Tandy and Apple lagging, and plenty of staggering wimps suffering erosion during the period, including AST, Digital, Atari, Tulip, Commodore, and Kaypro.* A third group of companies are “rookies,” brand-new companies, perhaps in brand-new industries, whose entire context has virtually no track record. These are frontier businesses, like steel in its day, automobiles in theirs, plastics a bit later, and the Internet at the turn of the twenty-first century. Apart from the first movers in such groups—say, Yahoo! and America Online (AOL) among the 1990s Internet companies—these have virtually no economic histories to speak of. Even so, there will be investors who have the present-day tools to make intelligent estimates of where the rookies will be in the future. By mating with AOL in 2000, senior managers of Time- Warner expressed just such confidence in their ability to do so. Whether their judgment will be vindicated remains to be seen. But certainly although some of these companies will turn out to be fly- by-nights, others are true up-and-comers that will proceed up the ranks from vintage warriors to stalwart classics. After all, every com- pany started out as a rookie. The central feature of the circle of competence, then, is that it must be tailored to the individual. It is not the case that intelligent investors avoid businesses that are hard to understand or subject to rapid change. On the contrary, those investors equipped with the ability and fortitude to understand what is hard for others to under- stand and to gauge better than others how a business and its industry are evolving have a decided advantage. But it remains important for each investor to come to grips with what is and what is not within his circle of competence to make the informed judgments that in- telligent investing requires. * Kara Scannell, Anatomy of a Bull Run: “New Economy” Stocks Lead Charge: Blast From the Past—A Look at Yesterday’s Tech Investments—A Few Thrive, Others Merely Survive, Some Fail, The Wall Street Journal, January 18, 2000. Introduction: The Q Culture xv The next inquiry is what to look for, within your circle of com- petence. The main question is the certainty with which you can evaluate the long-term economic characteristics of a business. A greater degree of confidence may be necessary for rookies, less for vintage companies, and least for classics; but in all cases, assessing the long-term characteristics of business performance is crucial. Obtaining the necessary degree of confidence in valuation entails just a few quantitative inquiries. You’ll see in the second part of the book that financial statements must enable you to answer three questions about a busin