Buffettology

Without a doubt, the best book I have ever read on investing is The New Buffettology, by Mary Buffett and David Clark.

I was excited to get this book, and was about learn and understand the investing strategy of the world's richest man (at the time).  The lesson was simple enough.  Buffett invested in companies with a durable competitive advantage.  The book explained that businesses that had a durable competitive advantage were the ones that were most likely to grow into the distant future.  It named quite a few of these companies - CocaCola, Gillette, H&R Block, etc.



Another thing that the book stressed was not only to pick the right companies, but wait until they were the right price.  Again, using the CocaCola example, Buffett loved this company, but there has only been one period when it was cheap enough for Buffett to consider it a good buy - so he bought 8% of it - at the right price.

The book describes how Buffett likes to price the companies.  In particular, he likes to know is Initial Rate of Return (IRR), and how quickly his investing capital will grow over time.  Buffett uses the earnings yield as his measure of his initial rate of return, irrespective of whether or not those earnings are dividends (ie, the dividend yield) or retained.  His rational for considering the entire earnings yield as his return, is that as the (part) owner of the company, the earnings are still (part) his, whether or not they are distributed.

This rationale holds of for quality companies with good management, where retained earnings are fed back into the growth engine - which is Buffett's first filter anyway, so within that investing strategy, it holds as true.

So, Buffett looks for IRRs of at least 12%, but an IRR that low would be reserved for only the best companies.  Often 20% would be used.  Converting IRR to P/E, that means that a max P/E of 8.

Buffett then uses the growth rate of the company based on retained earnings and returns on capital.  He likes consistent companies, as he does want to make bold predictions.  In fact, the predictions that he loves the most are that the company will do nothing different in the next 10 years than it has done in the last 10 years.  For companies like Coca Cola, you can see why this is a pretty safe bet - which is when the right price comes along, Buffett is prepared to bet billions on it.

What really convinced me though was that Buffett doesn't like to sell his shares.  If you bought a piece of a great company for a great price, why would you ever sell?  Here's the kicker.  One of the reasons list in the book as to why Buffett would ever sell a company was "if a company changes it's business model that introduces risk".  The example given was Freddie Mac. Buffett, unlike many others, had spotted that they had changed their business model, and introduced a risk that Buffett wasn't comfortable with.  So, he sold his shares.  I was reading this 2 months after it had gone under.