Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?
Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.
Smith: But there’s 27,000 public companies.
Buffett: Well, start with the A’s.
I was recently reading some forum posts by Warren Buffett’s biographer, Alice Schroeder. Alice wrote that much of what Buffett does is screening. Not with a computer model of course, but just scanning page after page with his eyes. In fact this is the way he began too. When Buffett began his investing partnership he took a copies of the moody’s manuals, which were many thousands of pages long, and flipped through them page by page. He did this with each one more than once too. In the beginning he was able to compound money at rates north of 30% per year with the moody’s manuals as his guide.
That gets one to thinking… what was in those manuals? Not much. They had the company name, a description of the business, its properties and subsidiaries, a list of officers and directors, a basic income statement and balance sheet for the last 2 years, and a description of the capital structure. If you would like to see samples here are two:
He wasn’t projecting earnings, he wasn’t doing a discounted cash flow analysis and complex financial modeling. He still doesn’t do those things today. Don’t believe me? Here is Alice explaining: http://www.youtube.com/watch?v=uOcdhDxqxCU&feature=related
If the greatest investor in the history of the world doesn’t do discounted cash flow and projections, why should I? I’m not saying that a DCF is completely useless, just almost useless. I am at odds with Bruce Greenwald on this one. I saw him speak in Omaha two weeks ago where he announced that DCF was a “complete waste of time.” I think it is an almost complete waste of time. I think it is useful if you reverse engineer it. It is much easier to make a binary judgement on market expectations than to try and project earnings. This is all for another post though. Back to the topic.
Alice said that Buffett would look for a 15% return day one and let it grow from there. So Buffett needed to make sure that he was going to get a 15% earnings yield and that the return would likely grow. Of course this isn’t the only way he invests, but it is one of the ways he invests. Buffett often likes to say that he would rather be vaguely right than precisely wrong.
So how do we know if a business will give us a 15% return day one. When you buy a business you are paying for a stream of earnings. If a business earns $10 and you pay $100 then you are getting a 10% earnings yield. In this way a stock is just like a bond except without a call or maturity date. Additionally that earnings yield can grow as the business earns more and more. The trick now is finding businesses that give you a 15% earnings yield and maybe more.
Our advantage over Buffett
When Buffett worked at Benjamin Graham’s hedge fund, he sat in an office next to Walter Schloss and calculated net current asset values (looking for stocks trading below their liquidation value) hour after hour, day after day. Today that would take less than one one-thousandth of a second. At my fingertips I can scan 10,000 publicly traded companies faster than an eye-blink. I just did it and found 64 companies trading for a conservative estimate of net current assets. I just did Buffett’s entire calculation job at the Graham-Newman partnership faster than it takes to say booya! Earnings yields can be found the same way. In fact even complicated formulas can now be applied and even backtested in nano seconds.
This means that we could narrow the universe down to only companies that are likely to give us our desired 15%.
I’m sure that Buffett gained a lot more from flipping through the Moody’s manuals than just which stocks to buy that day. The mental database and work ethic that was built is part of what has made him a legend. However, unless you are Warren Buffett, you have a great deal to gain by using modern screening technology.