Hagstrom: The Warren Buffett Way

TLDR

In this book, you'll learn the principles that guided Warren Buffett to become one of the most successful entrepreneurs in the world. With a fortune estimated at $109B, he has consistently been named one of the richest people in the world by Forbes magazine and his methodologies have been proven to be successful over a long investing career.

 

Have you ever wondered how successful investors make their decisions in today's volatile market? Look no further than "The Warren Buffett Way" by Robert G. Hagstrom. With 9 books published in finance and economics, Hagstrom is a highly accomplished author and expert in the field of investment. He has spent years researching interdisciplinary investment decision models, while also receiving the prestigious CFA certification as well as a master's in the liberal art of investment. He is most recently serving as a senior portfolio manager at EquityCompass.

Unlike the current trend of focusing on quick returns, this book teaches you how to develop consistent skills for evaluating companies and stocks. By following Buffett's investment advice, you'll gain valuable insight into the art of stock evaluation.

Background

Over the last six decades, Warren Buffett has established himself as a successful investor in the stock market. His methodology primarily centers on the value and market price of a business. As soon as Buffett finds a business that he is comfortable with, he behaves as a business owner, not a stock market speculator. Buffett investigates every possible aspect of the business and becomes an expert in that field. He collaborates with the management rather than opposing them. Whenever he buys shares in a company, he frequently grants the managers his proxy vote for his shares to assure them that he won't deviate from the company's core values. Buffett is a strong advocate of the value investment strategy, and he disregards day-to-day movements in share prices, the overall economic climate, or any other external factors. He keeps a long-term perspective at all times and never overlooks the underlying value of a business.

Investment Influences & Foundations

Ben Graham

Warren Buffett, who learned from his Columbia professor and friend Benjamin Graham, applied many of his concepts in his investment management approach. Buffett considered Graham to be his mentor and credited him with much of his success in the stock market. Graham described three approaches to investing in common stocks:

1. The Cross-Section Approach. 
   The investment strategy involves purchasing shares in companies across all market sectors. This approach ensures that no matter how the economy performs, at least one stock will yield good results.
    
2. The Anticipation Approach. 
   
       Short-Term Selectivity: The most common investment approach used by sharebrokers is to invest in companies with a favorable outlook for the next 6 months to a year, even though this approach can be volatile and superficial.
       Growth Stocks: The aim is to invest in companies with sales and earnings growth rates that are higher than average businesses. The strategy involves purchasing stocks in companies with products that are in the early stages of their life cycle and are expected to experience an increase in profits and revenues. However, accurately predicting growth rates can be challenging.
   
   
3. Margin of Safety Approach. 
   Investing in companies with a large margin between earnings and fixed costs can help weather economic downturns. When buying stocks, it's important to ensure the share price is below the intrinsic value; determined by assets, earnings, dividends, and future prospects. Graham's approach to investing in growth company stocks was to purchase them when trading below their intrinsic value. Although buying at market lows is a popular objective, Graham believed that identifying undervalued stocks, regardless of market sentiment, was the key to investment success. Intrinsic value is determined by a company's future earnings power and fixed costs, which can be challenging to accurately calculate.

Ben Graham also advocated for two approaches when purchasing shares: 

1. Buy for less than two-thirds of its net asset value. 
2. Concentrate on stocks with a low price-to-earnings ratio, as they are usually unpopular with the market sentiment. The investor can benefit from the market's inefficiency, caused by emotions, which creates valuable opportunities.
   

Philip Fisher

Philip Fisher was an influential investor and author whose ideas greatly impacted Warren Buffett's investment strategy. Fisher's approach to investing, which emphasized the importance of analyzing a company's management, products, and long-term growth potential, helped shape Buffett's investment philosophy. Fisher's book "Common Stocks and Uncommon Profits" was a major influence on Buffett, who has frequently cited Fisher as one of the most important figures in his investment career. Fisher classified companies into two different groups: 

1. Fortunate and able. 
   Companies that actively seek to expand their markets and can take advantage of external events.
2. Fortunate because they were able. 
   Companies that prioritize continuous research and development to create innovative and improved products to capture new markets.

Fisher evaluated various aspects of a company such as its sales organization, research and development capabilities, profit margins, and accounting controls. He believed that marginal companies did not succeed in the long run and looked for companies that maintained their competitive advantage and market position. He sought out companies that could grow without needing additional equity financing, and those that relied on the strength of their products and services to expand. Fisher also placed a high value on above-average management capabilities and communication with shareholders during tough times. He looked for unique characteristics of each company by interviewing customers, vendors, competitors, and consultants. Fisher believed in investing in a few outstanding companies rather than many average ones, within his own circle of competence - companies that he understood and felt comfortable with.

Foundational Ideas

Warren Buffett has a patient investment strategy that is based on the value of a business, which he assesses by looking at a share purchase as a business owner rather than a stock market trader. Short-term stock market fluctuations do not guide his investment decisions; instead, he relies on companies' operating results.

1. Distinguishing between investing in a specific stock and anticipating the general market's direction is essential. People still drive markets, despite technology. Short-term market direction and stability are primarily determined by investor sentiment. Nevertheless, the economic growth of a company, not day-to-day market fluctuations, eventually determines a stock's long-term value.
   
   
2. In the Mr. Market Allegory, an investor is in a partnership with Mr. Market, who provides daily quotes to buy or sell their half of the business. Despite the business's good progress, Mr. Market's quotes vary greatly depending on his mood, resulting in an emotional rollercoaster ride for the investor. Successful stock market investors should ignore Mr. Market's emotional fluctuations and concentrate on making sound investment decisions, and buy businesses for under their worth despite Mr. Market's so-called wisdom.
   
   
3. Investors need to be financially and emotionally prepared to face daily market fluctuations. If you're easily frightened by a 50-percent drop in the value of your stock holdings, you're unlikely to succeed in investing.
   
   
4. Adding more shares to your portfolio at a lower price is a good opportunity, which is presented through price declines. A soundly run business with good fundamentals, management, and prices should be invested in, as the market will eventually recognize its success.
   
   
5. Buffett's approach to investing in the stock market is to hold shares in outstanding and well-managed businesses. He does not rush to buy and sell mediocre stocks based on rumors but waits patiently until a great investment opportunity emerges. By doing so, he can say "no" unless all the facts are in his favor, which is a significant advantage in the stock market.
   
   
6. Achieving investment success does not require infallibility; instead, it is about making more right decisions than wrong ones. The key is to minimize the potential for mistakes and concentrate on opportunities where you have the most confidence in your ability to make the right call.
   
   
7. In the Market Rumor Parable, an oil prospector was denied entry to heaven due to overcrowding. However, he was allowed to make a statement to other oil prospectors. He shouted, "Oil discovered in Hell!" and all the oil men ran out of heaven to head for hell. Impressed by his cleverness, St. Peter invited him in, but the prospector declined, choosing to follow the others instead just in case the rumors were right. This parable highlights the irrational and herd-like behavior of stock market investors, including institutions. Warren Buffett is not swayed by the opinions of others and does not base his investment decisions on rumors or following the crowd.
   
   
8. When investing in a company, it is important to view it as a business to be purchased rather than just a stock. The first question any potential buyer should ask is the company's overall potential to generate cash. The value of a company will be directly linked to its cash-generating capacity over time. By adopting the same mindset as a business owner, an investor can make more informed investment decisions. It is helpful to shift your focus from buying and selling shares in a company to buying and selling a business that you would like to own.
   
   
9. Instead of relying on short-term price fluctuations to determine the success of a company, it is important to consider economic criteria, such as:
   
   
       - Return on beginning shareholder’s equity
       - Changes in operating margin
       - Changes in debt level
       - The company’s ability to generate cash
   
   
   By focusing on these measures, investors can better evaluate a company's long-term potential for success.
   
   
10. It is important for investors to take a relationship investing approach, where they act as owners of the companies they invest in. They provide patient capital, allowing the management to pursue long-term growth opportunities. This involves holding stocks for an extended period and working collaboratively with management to enhance the company's performance.
    
    
11. Buffett typically assigns voting rights to the management of the companies he invests in, indicating that he is not seeking changes. He avoids companies that need major restructuring or confrontations with management to improve shareholder returns. Buffett only invests in companies that do not require a change in officers to realize the true value. He does not look for companies undergoing a turnaround or restructuring as there are too many variables.
    
    
12. Investors must hold securities for a long time, but only if the company has satisfactory returns on equity capital, competent and shareholder-oriented management, and isn't overvalued by the market. He tends to sell only when the stock price significantly exceeds his assessment of the company's value.

Buffett's Consolidated Approach

Warren Buffett, widely known as the Oracle of Omaha, is one of the most successful investors of all time. He has built a reputation as a savvy investor who has consistently generated impressive returns over many years. Buffett's asset management is based on long-term investments of 10 to 20 years for consistent profits. Utilizing what he was taught by his mentors and putting his own twists on their philosophies, he has created his own investment management into four main principles:

1. Don't track daily changes in the stock market.

The primary function of the stock market is to facilitate the trading of shares and not to determine their value. It is only practical to monitor market trends if there is a chance of buying a stock at a bargain price. Investors who rely on the market's ability to predict future prices often encounter difficulties. The critical consideration is whether one has conducted thorough research on the company. If an investor possesses more knowledge about the business than the market does, there is no need to heed the market's views. Additionally, if a share is acquired based on its promising financial outlook for long-term ownership, the market's day-to-day fluctuations become irrelevant. An investor doesn't need the market's validation for any shares purchased. The main reason for observing market prices is to identify opportunities where a sound business may be selling at a discounted price.

2. Don't attempt to scrutinize or be concerned with the overall state of the economy.

If it's not feasible to predict daily stock market changes, how can it be possible to predict the future of the overall economy? This is because some investors base their selection of stocks on their economic assumptions, leading to self-fulfilling and limiting predictions. It's more beneficial to invest in a company that has the potential to advance regardless of whether the economy is growing or declining. A business that can thrive in any economic condition is incredibly valuable.

3. Buy a business, don't trade stock shares. 

It's wise to purchase shares only in a company that an investor would buy outright if they had enough capital. In doing so, they should seek a company with comprehensible business operations, favorable long-term prospects, run by competent and truthful individuals, and available at a reasonable price.

With the mindset of treating a stock purchase as if the investor was buying the entire business, the following principles apply. These insights were gained from Hagstrom through 20 years of research on Berkshire Hathaway and its founder.

• Business Principle: The evaluation of the product or service quality.
  
  
• Do you find the business easy to understand?
  
  
  This means comprehending how the company creates revenue, spends money, and earns profits. It requires a comprehensive understanding of labor relations, cash flow, expenses, pricing, flexibility, and capital requirements. Therefore, it's advisable to purchase shares only in companies that align with your financial and intellectual understanding. Realistic expectations of what one doesn't know are important. The most successful outcomes are often achieved by executing ordinary things extraordinarily well.
  
  
• Does the business have a consistent operating history? 
  
  
  Businesses that have been providing the same product or service for many years generally have the best long-term profits. Unusual events that generate one-time windfalls are difficult to predict. It is important for an investor to not ignore the current reality of a business based on a vision of future success. Instead, they should look for a company that has proven to be able to withstand various economic and competitive forces. The optimal time to buy a business is when its profitability has been affected by a short-term external factor, creating a unique opportunity to purchase a strong business at a low price.
  
  
• Are the long-term prospects of the business favorable?


In the economic world, companies can be classified into two groups: franchise companies and commodity companies. Franchise companies are those that have a unique product or service which is in demand and has no substitutes, while commodity companies compete based on price with no differentiation between suppliers. Although franchise companies offer a margin of safety by allowing prices to be raised to offset management mistakes, they tend to attract competitors, which eventually leads to the creation of a commodity market. In such situations, the value of management becomes crucial to the company's economic performance. If a franchise company is not available for purchase, the next best option is to buy the lowest-cost supplier in a commodity market. Over time, the lowest-cost supplier dominates a commodity market, leading to long-term success.


• Management Principle: Observing who is responsible for the business.
  
  
• Are the company's managers rational?


To determine if a company's management is rational, its allocation of capital must be examined. Rational managers invest excess cash generated by the company in projects that produce earnings at rates higher than the cost of capital. The allocation of capital over the long term determines the value of the company. Companies move through an economic life cycle, with the final stages generating more cash than is necessary. Rational management invests this cash in projects that earn a higher rate of return than the cost of capital on the open market, while irrational management reinvests in projects with diminishing returns. Ultimately, the key question is what managers do with the excess cash in the maturity and decline stages. If the funds cannot be invested in higher-rate return projects, they should be returned to shareholders as dividends or by buying back the company's own shares.


• Does the management communicate with its shareholders honestly?
  
  
  A strong management team reports the company's financial performance openly and honestly. They are also willing to admit mistakes and keep shareholders updated on the progress of the company. The management's prime objective should always be to maximize the return on shareholder's investment, and every action should reflect this. A good management team will also provide shareholders with valuable information to help them judge the company's economic performance.
  
  
• Is management resistant to the institutional imperative?
  
  
  Corporate managers have a tendency to mimic the actions of other companies, even when these actions are destructive or irrational. Most managers are so influenced by what other companies are doing that they are unwilling to do anything that results in short-term pain in exchange for long-term profit. A sign of successful management is how effectively they think for themselves, rather than settle for a mindless imitation of what everyone else is doing. Managers who refuse to follow the herd into mediocrity are typically found in successful companies.
  
  
• Financial Principle: Projecting the business's profitability.
  
  
• Focus on return on equity rather than earnings per share.
  
  
  Return on equity is the operating earnings to shareholder equity ratio, measuring how well management can produce returns using the capital employed. Marketable securities should be valued at cost, not market value, and extraordinary items unrelated to the business should be excluded. An excellent management team will achieve good returns on equity with little to no debt or a manageable level of debt for the business.
  
  
• Calculate "Owner Earnings" for a better understanding of the company's cash flow.
  
  
  The ultimate value of a company lies in its ability to generate cash surpluses. However, companies with high fixed asset-to-profit ratios require a larger share of retained earnings to stay profitable than those with low ratios. To determine the true cash flow position of a company, "Owner Earnings" can be calculated by adding depreciation, depletion, and amortization charges to net income and subtracting the capital expenditure needed to maintain economic position and unit volume. This measure provides a cross-industry analysis, taking into account heavy expenditures for certain enterprises, such as real estate development, and regular plant upgrades for others, such as manufacturing.
  
  
• Look for companies with high-profit margins.
  
  
  Managers of low-cost operations tend to take pride in lowering expenses and the culling of unnecessary expenses is a consistent theme of effective managers. In contrast, managers of high-cost companies tend to find ways to continually add to their overheads which deprive shareholders of extra profits.
  
  
• Does a company create extra market value for each dollar of retained earnings?
  
  
  A well-managed company will add at least one dollar of market value for every dollar of retained earnings. Subtract all dividends from a company’s net income over the last ten years, then add that figure to the company’s market value at the beginning of the ten-year period to get Total A. If the market value at the end of the ten-year period doesn't exceed Total A, beware. 
  
  
• Market Principle: Estimating the value of the product to buyers.
  
  
• How to determine the value of a business?
  
  
  Buffett uses a conservative approach called the discounted cash-flow method. This involves calculating the net cash flows expected over the life of the business and discounting them at an appropriate interest rate. The interest rate used is typically something like the thirty-year U.S. treasury bond rate. The net cash flows are essentially the company's "Owner Earnings" over a long period. This method allows for the comparison of vastly different businesses. However, if a business is growing rapidly and has unpredictable future revenues, it cannot be classified as simple and understandable, and this formula cannot be applied. The discounted cash-flow approach is conservative as long as an appropriate discount rate is applied.
  
  
• Is the business currently available at a discount?
  
  
  After accurately calculating the value of the business, the next step is to compare it to the current asking price. To be successful in the market, it is essential to purchase a business only when the current market price is significantly lower than the value. The investor's margin of safety is the difference between the business value and its market price. Buffet's margin of safety is generally set at 25% but most investors have their own margin of safety. A well-chosen stock should have sound fundamentals that lead to above-average growth in the company's share price in the long term, which provides an additional reward for the intelligent investor who purchases at a discount.
  
  

4. Manage only a few businesses. 

Investing intelligently means adopting the mindset of a business owner, who focuses on long-term value, rather than that of a stock trader, who prioritizes short-term gains and losses. The idea is to buy shares in a company and act like you own the whole business, not just a piece of paper. To achieve this, it is necessary to have a thorough understanding of the company's operational fundamentals. Diversification is only necessary when an investor lacks knowledge and experience in a specific area. Few business owners are comfortable managing multiple companies at once. Therefore, investors should follow the same principle and only invest in companies that they understand well enough to act as an owner.

Key Quotes

"I have long felt that the only value of stock forecasters is to make fortune tellers look good."

"The market, like the Lord, helps those who help themselves, but unlike the Lord, the market does not forgive those who know not what they do."

"The most common cause of low prices is pessimism sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of rational buyers."

"An investor should act as though he had a lifetime decision card with just twenty punches in it. With every investment decision his card is punched, and he has one fewer for the rest of his life."

"Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it and one day running a business has exactly the same kind of value."

"Invest within your circle of competence. It’s not how big the circle is that counts, it’s how well you define the parameters."

"Beware of past performance proofs in finance. If history books were the key to riches, the Forbes 400 would consist of librarians."

"After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100 percent position in See’s or H.H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?"

"In our view, what makes sense in business also makes sense in stocks. An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of the business."

- Warren Buffett

"As time goes on, I get more and more convinced that the right method in investments is to put fairly large sums into enterprises that one thinks one knows something about and in management of which one thoroughly believes. It is a mistake to think that one limits one’s risks by spreading too much between enterprises about which one knows little and has no special reason for special confidence. One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel entitled to put full confidence."

- John Maynard Keynes

"The reasonable man adapts himself to the world. The unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man."

- George Bernard Shaw

"In the short run, the market is a voting machine but in the long run, it is a weighing machine."

- Ben Graham

"Rationality is the quality that Buffett thinks distinguishes his style with which he runs Berkshire - and the quality he often finds lacking in other corporations."

- Carol Loomis

"The size of an investor’s brain is less important than his ability to detach the brain from emotions."

- Robert G. Hagstrom

Conclusion

The Warren Buffett Way provides a comprehensive overview of the investment strategies of one of the most successful investors of all time. The book outlines the key principles that have guided Buffett's investment philosophy and provide insights into his approach to stock selection. Whether you are a seasoned investor or a beginner, The Warren Buffett Way provides valuable insights into the principles of value investing and the strategies that have made Warren Buffett a legend in the world of investing. By following the principles outlined in the book, you can develop your own investment philosophy and increase your chances of success in the stock market. By taking a long-term investment horizon and focusing on the underlying financials and management of companies, you can make informed investment decisions and build a portfolio of undervalued stocks that are positioned for future growth.