Tuesday, 8th December 2009

Warren Buffett Investment Lessons, part 6

Written by George Traganidas Topics: Stock Investing

Debt and Leverage

Warren Buffett prefers to get finance (debt) in anticipation of need rather than in reaction to it. Warren Buffet has an aversion to debt, particularly the short-term kind. He is willing to incur modest amounts of debt when it is both properly structured and of significant benefit to shareholders.

Warren Buffett does not like leverage. Even if the odds of disaster are 99:1, he does not like them. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results.

From a risk standpoint, it is far safer to have earnings from ten diverse and uncorrelated utility operations that cover interest charges by, say, a 2:1 ratio than it is to have far greater coverage provided by a single utility.

Arbitrage

Warren Buffett says that you need to answer the following four questions in order to evaluate arbitrage situations:

  • How likely is that the promised event will indeed occur?
  • How long will your money be tied up?
  • What chance is there that something still better will transpire (e.g. a competing takeover bid)
  • What will happen if the event does not take place?

Diversification

Warren Buffett made the following comments on diversification in his 1993 chairman’s letter.

We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In starting this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: “Too much of a good thing can be wonderful.”

Investment Risk

In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are:

1) The certainty with which the long-term economic characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

Follow the practical way,
George

Bookmark and Share


Search