How Warren Buffett would get a 50% Return with a Million Dollars
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Main Topic: How Buffett would get a 50% return with just a million dollars
In November of 2008. Alice Shroeder, author of the book “Snowball: Warren Buffett and the Business of Life” gave a talk at the Darden MBA Value Investing Coference. The subject of this talk was a case study on the Investment Filters of Warren Buffett.
The reason that Alice chose that particular topic is that she had experienced the irritation many investors have had to a statement that Warren Buffett made that if he was working with only a million dollars, he would be getting a 50% return per year.
Now, I have personally spent a considerable amount of time ruminating over this statement by Buffett. The man has a way of boiling down complicated subjects to simple rules of thumb and precise analogies. There is a ton of truth in every concise statement he makes.
When I found a transcript of this talk by Alice, I was immediately fixated on it. The answer to this riddle was so incredibly simple, and made such enormous sense to me, that it was almost too obvious. As Alice points out, it’s not just that Buffett is a genius, and we are all dumb, the truth is somewhere in between. Alice Shroeder has had access to Buffett’s personal papers and account records and you can trust what she says to be the truth.
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Alice said, “Buffett has a some concepts and habits that are so imbedded in him that he doesn’t even understand them himself.” If you were to ask him about them, he might say something as if it came from inside him, when in fact, it originated from an external source that he internalized so much, it became part of him. “..some of the ideas are so ingrained in him from an early age that it is hard to know whether they are innate or whether he invented them or whether he picked them up from sources like this when he was very young.”
So the first key element to solve the 50% riddle is to understand that when Buffett says it’s simple, he means that if you follow the rules of thumb, concepts and ingrained habits that HE has, it is simple. For YOU to duplicate his investing success you would have to have all the same rules of thumb and ingrained habits that HE does..and you don’t have them.
Let’s review some of these rules of thumb, concepts and ingrained habits that are the basics of value investing:
- Intrinsic Value – the calculated value of a business
- Ignoring Mr. Market’s manic depressive behavior
- Performance drag of too much turnover and too much diversification
- Ben Graham’s margin of safety concept
These are the most important investing concepts as accepted by the cadre of professional value investors. These are the concepts Buffett himself give the credit to for his great success. But there is more to it, as Alice goes on to illustrate in her talk.
She says “…so much of Warren’s success has come from training himself in good habits.” Buffett himself likes to say that, “the chains of habit are too light to be felt until they are too heavy to be broken.” So it is good habits ingrained from an early age. For example, one of his quote about “it is never pleasant to depart forever from an old friend” actually came from a book he read when he was seven years old called “Bond Salesmanship”. Yes, as a seven year old, he read a book about bonds.
That alone sets Buffett apart from nearly every seven year old in his age cohort. To have such an interest in investing at seven years old is one reason for the man’s great success. If you want to become a professional golfer, most experts say you should start by the age of 3 or 4. So developing good investing knowledge and habits early on was a major advantage for Buffett.
The second key to understanding the 50% riddle is that Buffett works hard and loves to learn. He works really really hard. In fact, he pretty much works all the time. In the early days of the Buffett partnerships, he would travel to New York, to the office of the SEC to dig through filings. No-one else was there doing that. He was able to generate his own high-value investment ideas by doing things no-one else was doing.
Alice said.“But for the few that work obsessively, there is a reward. The main thing he worked at was learning.” Charlie Munger said, “Buffett is a learning machine.” Learning is cumulative, so over time, you can turn your gathered knowledge into a competitive advantage just like Buffett has some. So the second key to the 50% riddle is to work hard and learn voraciously.
The third key to the 50% riddle is how handicapping, compounding, and margin of safety work together to generate wealth. In her talk, Alice used a case study to illustrate this third key to the 50% riddle. I have summarized the key points here:
- In his personal portfolio, Buffett invested in a company that made tab cards, which were used to input data into early computers.
- IBM divested a similar business as part of a settlement with the Department of Justice.
- The business had margins of 50% and was therefore incredibly profitable.
- Buffett’s friends decided to compete against this company and make their own tab cards and asked Buffett to invest
- Handicapping – Buffett initially said no.
- He starts with what can go wrong by asking “what are the odds that this business could be subject to any type of catastrophe risk that could make it fail.” If there is any chance that any significant part of his capital would be subject to catastrophe risk, he just stops thinking.” In this case he said no because he thought a start-up could not compete against IBM.
- Buffett didn’t get involved until the friends had started the company, and successfully competed against IBM, printing 35 million tab cards a MONTH. Now the catastrophe risk was eliminated
- Compounding – The friends were turning their capital over seven times a year. Each new machine cost $78,000 and they were making over $11,000 with each run. At seven runs per year, they could buy a new machine every year with each machine. Net profit margins were 36%, one of the most profitable businesses he had been able to invest in.
- Margin of Safety – Buffett thought, with 36% margins, growing sales at 70% per year with starting sales of $1mm, he could get 15% on $2mm of sales (his return for his investment) and compound from there.
- Buffett doesn’t do DCF models. He keeps things simple. ‘I want 15% on $2mm in sales.” That is the return he wants day one. He’s not too greedy.
- Buffett asked for half of the profit margin or 18% and put up $60,000 of his personal, non-partnership money (20% of his $300k net worth) for 16% equity plus some subordinated notes.
- He made this decision with only historical figures and no projections.
- Buffett did this type of analysis repeatedly on many different investments.
How did that work out? He received a 33% compounded annual return for 18 years and multiplied his capital by almost 20x.
There are two key investment criteria that strike me from this story.
- Buffett’s first gate is catastrophic risk and permanent loss of capital. If that is a possibility, he says no. Such a simple, elegant, and efficient way to triage ideas. In practice, you will need significant insight into how and why businesses fail.
- Buffett has a return criteria of 15% as a minimum he would take to make an investment. This criteria keeps him focused on only the investments with the highest potential returns
The secret to the 50% annual return is to insist on a fifty-percent return with no possibility of permanent capital loss. Don’t invest in anything with less potential return. Be patient and wait for the 50% return whale to swim by, then harpoon it.
Ask JB: Why should ADNT sell at twelve times earnings and what does buying equity get you?
Ask JB: Nicholas asks: Hi JB,
Why do you think 12x PE is a fair PE for ADNT. Is this valuation based against its peers or industry average or something else. Thanks.
JB Says: When estimating what a company could sell for in the market, I use 12x P/E as a rule-of-thumb proxy for a decently run company with modest growth potential and reasonable leverage. If I would get my required return if ADNT sells for that multiple, that is one hurdle passed. You can compare to competitors like Lear Corp (10x P/E) but overall industry multiples may be depressed at any given time, so I use a proxy for what I think an ADNT-type company should sell for in a normalized market / industry.
submitted 8 hours ago by tone3000
JB Says: The investor gets 20% of the company as valued at the time of the deal. For example, if the company is valued at $1,000,000 and the investor is buying 20%, he would pony up $200,000 for his 20%. If the investment is for common stock, that would give the investor 20% of the voting shares, and rights to any dividends declared, and 20% of the liquidation value if the company is shut down. If the company is sold, the investor would get 20% of the net proceeds.
Most companies that are growing will be reinvesting everything they make, so there will not be dividends. Those retained earnings will help the company to become more valuable so that the investors 20% ownership will increase in value over time.
Eventually, the company can go public, or be bought in a private transaction to unlock the value that has been built up.
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