Buffett Partnership Letters by Warren Buffett summary

July 12, 2022

Buffett thinks most markets are not purely efficient and that equating volatility (beta, shows how volatile the security is compared to the market) with risk is a gross distortion.
From 1957 to 1968, the Buffett Partnership earned a 31.6% annual return (25.3% for limited partners), with no losing years, compared to 9.1% for the Dow.
Buffett saw a satisfactory return as one that beat the Dow by 10% over the long term. And if he could not beat the Dow, it was best for the partners to invest through someone else.
His goal was to outperform in bear markets with average performance in bull markets — targeting a half percent decline for each 1% decline in the Dow. He constantly reminded the partners of it — tempered their expectations — every time he handily beat the Dow.
He favored a conservative approach, avoiding permanent capital loss.
3 years is his minimum time needed to judge good performance (5 years is better), assuming the period saw both strong and weak markets.
“At all times, I attempt to have a portion of our portfolio in securities as least partially insulated from the behavior of the market, and this portion should increase as the market rises.”
Three suggestions for investors from Buffett: First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Finally, be suspicious of companies that trumpet earnings projections and growth expectations.
Buffett’s Fees: one-fourth of profits above 6% per year, with any year falling short of 6% in profits would be carried forward against future profits.
Indexes are tough competition to beat:
- Buffett annually compared four of the largest mutual funds at the time against the Dow: “I present this data to indicate the Dow as an investment competitor is no pushover, and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.”
- The lack of outperformance from the funds was due, in his opinion, to a combination of group decisions making it harder to come to a consensus decision, desire to conform (herd mentality) to what other funds are doing, that average performance is safer than the risk of being different, broad diversification, and inertia.
- That said, Buffett does see a benefit in mutual funds despite their lack of alpha — ease of use, freedom from decision making, automatic diversification, and a better alternative than the speculative trouble an investor can get into on their own.
The size of a portfolio can help or hurt returns depending on how its invested — helpful in control situations, hurtful in passive investments.
A conservative portfolio is measured by how well it performs in a bear market.
Good or bad performance should be measured against a benchmark(s), not by gains or losses in a year. Investors should objectively evaluate their performance against that benchmark.
“What I can and do promise is that: Our investments will be chosen on the basis of value, not popularity; that we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments…”
Joys of Compounding:
- Assume the voyage of Columbus had been underwritten with $30,000 in venture capital. Had the money been invested differently, say at 4% compounded annually to the present (i.e. 1962), Spain would have watched it grow to $2 trillion.
- Assume Francis I of France paid $20,000 for Leonardo da Vinci’s Mona Lisa in 1540. Had he instead invested the money at 6% compounded annually (after-tax, of course), his estate would worth $1 quadrillion.
- Manhattan was sold in 1626 to Peter Minuit for the rough equivalent of $24. Who got the better deal? A 1965 appraisal, at $20 per square foot puts the value at $12.5 billion. But had the Indians invested that $24 at 6.5%, it would be worth $42 billion over the same time. If they got a half point better — 7% instead — they’d have $205 billion!
Conservative investing is not the same as conventional investing. There are times when a conservative approach means being conventional — investing like everyone else — but there will also be times when a conservative approach means being unconventional. Conservative investing is not about seeking agreement with others but making a proper assessment of many situations while maintaining the primary goal of avoiding the temporary and permanent loss of capital.
The goal of investing is to earn the best after-tax return possible, which is not the same as paying the lowest amount of taxes. Holding on to investments to avoid paying taxes is often at odds with earning the best after-tax return.
Investing is about probabilities and expectations which results can diverge from in the short term.
Position Sizing: He based it on the probability that an investment might result in worse relative performance to the Dow. Given two stocks with the same expected returns, the one with the lower probability of performing worse than the Dow gets the higher weighting in the portfolio. Overall weighting is determined by how tiny the probability can get. He was willing to go as high as 40% in any one position.
The beginning of 1967 was the first time Buffett complained about finding a lack of good opportunities. He questioned whether it was due to a change in the market environment, portfolio size, or more competition. He refused to invest outside his comfort zone, or chase the popular tech stock craze of the late ’60s.
By the end of 1967, Buffett said it was no longer possible for him to beat the Dow by 10% due to the late ’60s market behavior (he changed it to 5% over the Dow or 9%, whichever is lower). He saw a “distortion of a sound idea” — a shift in focus from long term performance to short term performance, leading to speculation in order to achieve the highest returns possible in the shortest amount of time. Buffett wasn’t willing to change his strategy to something he didn’t understand just to compete against the Go-Go funds. He would rather pass on the large, easy profits because of the risk of large capital losses that came with it. 1967 was the first time he floated the possibility of retiring.
On Quantitative vs. Qualitative Analysis: both approaches can be used to make money. Investors who prefer one or the other, likely combine the two to some extent. Buffett considers himself of the quantitative type, but said his best ideas were qualitative — only when he had a “high probability insight.” But those insights are rare. The quantitative side needs no insight — the numbers are either obvious or not.
Better to work with quality management that earn a decent return than chase a few percentage points higher returns by working with horrible management.
Recommended partners read The Money Game in 1968.
Go-Go Fund manager on investing in 1968: “The complexities of national and international economics make money management a full-time job. A good money manager cannot maintain a study of securities on a week-by-week or even a day-by-day basis. Securities must be studied in a minute-by-minute program.”
Buffett announced his retirement in the May 1969 letter and offered a plan to liquate the partnership.
Recommended partners invest with Bill Ruane — Buffett’s classmate in Ben Graham’s class at Columbia — after the partnership liquidation. He earned similar returns to the partnership with more volatility.
Buy bonds like you would stocks — only invest in what you understand.
Bond maturity: selection should be based on the shape of yield curve, the expectation of future interest rates (most difficult to assess), and the ability to stomach price fluctuation.
Portfolio Construction:
- Generals:
  - Undervalued securities, with a wide margin of safety, no view on corporate policy or when price appreciation might occur.
  - Bargain price is a must, but also good management or new management in a decent industry.
  - He likes to see companies with improving earnings/increasing asset values, that the market hasn’t recognized yet.
  - It’s the largest portion of the portfolio with the best total returns.
  - Individual position size: 5% – 10% for each of 5 or 6 generals, with small positions in 10-15 others.
  - More concerned about buying at the right price then selling at the best price — squeezing the last penny out of a deal. He was happy selling below fair value.
  - Tend to move with the market — performing well in rising markets, poorly in declining markets.
  - In the 1964 letter, he split Generals into two groups: “Private Owner Basis” and “Relatively Undervalued.” The “Private Owner Basis” were the typical Generals as described above. The “Relatively Undervalued” were securities selling cheap relative to other similar securities.
- Workouts (i.e. Special Situations):
  - Are dependent on a specific corporate action or event in order to profit, making it easier to predict when and how much could be earned, and the risk of it falling through.
  - Usually the result of corporate sales, spinoffs, mergers, liquidations, tenders, reorganizations, etc.
  - The risk is that something — anti-trust issue, shareholder disapproval — causes management to abandon the planned action or event making any potential profit impossible. Misjudging the risk can be expensive.
  - Tend to perform independently to the stock market.
  - Workouts are used to insulate a portion of the portfolio from the short term (mis)behavior of markets. Typically, performing better in bear markets but lagging in bull markets.
  - The second-largest portion of the portfolio.
  - Typically in 10-15 workouts at any time.
  - Buffett used borrowed money in workouts — a borrowing limit of 25% of the portfolio’s net worth — because of the higher degree of safety due to predictability of results and lower chance of short-term declines.
- Control Situations:
  - The activist role: Buy a controlling interest in a company or a large enough position to influence corporate policy (he would rather others did the work).
  - It requires a wide margin of safety and a large profit potential to be worthwhile.
  - Each situation is expected to take several years — to gain enough shares to assume control and to realize a profit.
  - Generals may become control situations if the price remains low for a long enough time.
  - It can insulate the portfolio from short-term market moves, like workouts.
  - Tend to move independently to the market.
  - Once controlled, market price was irrelevant. Operating performance of the business was all that mattered.
Mentioned Holdings:
- Commonwealth Trust Co. (1958 Letter)
  - 10 to 20% position in the three partnerships at the time — at roughly 12% of outstanding shares.
  - The average purchase price was $51. The intrinsic value was $125. $10/share in earnings. $50 million in assets.
  - A large bank owned 25.5% of outstanding shares, with the potential to merge.
  - Illiquid, inactive stock — only 300 shareholders with 2-3 trades per month.
  - Buffett eventually sold it for a profit — $80/share — because he found a (better) investment in a control situation.
Sanborn Map (1960 Letter)
- 35% position in the portfolio
- Buffett’s first attempt as an activist investor in a control situation.
- Published and revised detailed city maps — showing water mains, fire hydrants, roof types, etc. — in the U.S. mostly for fire insurance companies.
- The map was a monopoly, that eventually declined due to a new, competitive method of underwriting that didn’t require maps.
- But it also held a substantial investment portfolio.
- In 1958, shares sold at $45/share, valuing the investment portfolio at 70 cents on the dollar and getting the map business free.
- The goal was to separate the two, the portfolio from the map business, to realize the fair value of the portfolio and make the map business profitable again.
- The board objected, instead offering to exchange Sanborn stock for the securities in the investment portfolio.
Dempster Mill Manufacturing Company (1961 Letter)
- Started as a general but took control (70%) in 1961 — started buying shares five years prior, with an average price of $28/share.
- Highly inactive market for the shares, only 15 shareholders.
- Manufuctured farm equipment and water systems.
- Had static revenue and no profits over the prior decade.
- Initially used a 40% discount on inventory and a 15% discount on receivables in estimating value.
- The goal was to sell off assets and turnaround the company by restoring earnings.
- Installed new management — Harry Bottle — after old management refused to make changes.
- Bottle exceeded expectations. He sold assets for cash and turned Dempster profitable.
- Excess cash — from asset sales and profits — was invested in undervalued securities via a portfolio within Dempster. The portfolio was initially valued at $35/share — higher than the average purchase price of Dempster stock — plus the newly profitable business.
- The business (minus the portfolio) was sold in 1963 at $80/share. The partnership retained control of the portfolio.
Berkshire Hathaway
- Announced a controlling interest in the November 1965 letter.
- Initially bought as a General.
- Bought below net current asset value – initially valued it at 100% current assets and 50% fixed asset.
- Bought National Indemnity and National Fire and Marine through Berkshire in 1967.
- Bought Illinois National Bank and Trust Co. through Berkshire in 1969.
- Buffett had low expectations of the textile business in 1969. He was more enthusiastic about the insurance and bank businesses. He didn’t want to liquidate the textile business and put 1,100 people out of work (so long as the textile business earned a decent profit and did not need large additional amounts of capital).
How Buffett and Charlie Munger run Berkshire
- Buffett and Berkshire avoid making predictions and tell their managers to do the same. They think it is a bad managerial habit that too often leads managers to make up their financial reports.
- Buffett just gives a simple set of commands to his CEOs: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies whose short-term oriented shareholders obsess with meeting the latest quarterly earnings estimate. Short-term results matter, of course, but the Berkshire approach avoids any pressure to achieve them at the expense of strengthening long-term competitive advantages.
- Stock splits are another common action in corporate America that Buffett points out disserve owner interests. Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices that depart materially from intrinsic business value.
- Intrinsic value: The discounted value of the cash that can be taken out of a business during its remaining life. Charlie and Berkshire are interested only in acquisitions that they believe will raise the per-share intrinsic value of Berkshire’s stock.
- According to Buffett: Useful financial statements must enable a user to answer three basic questions about a business: approximately how much a company is worth, its likely ability to meet its future obligations, and how good a job its managers are doing in operating the business. Charlie and Buffett think that it is both deceptive and dangerous for CEOs to predict growth rates for their companies.
- “At Berkshire, we try to be as logical about compensation as about capital allocation. For example, we compensate Ralph Schey based upon the results of Scott Fetzer rather than those of Berkshire. What could make more sense, since he’s responsible for one operation but not the other? A cash bonus or a stock option tied to the fortunes of Berkshire would provide totally capricious rewards to Ralph. He could, for example, be hitting home runs at Scott Fetzer while Charlie and I rang up mistakes at Berkshire, thereby negating his efforts many times over. Conversely, why should option profits or bonuses be heaped upon Ralph if good things are occurring in other parts of Berkshire but Scott Fetzer is lagging?”
- “Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
- “It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price-one not reimbursable by the companies”
- “Audit committees should unequivocally put auditors on the spot, making them understand they will become liable for major monetary penalties if they don’t come forth with what they know or suspect.”

Buffet’s principles and rules of value investing

the data and qualitative information from 10K and 10Q reports can be used to evaluate the following principles:
- Vigilant leadership
- long-term prospects
- stock stability
- buy at attractive prices

vigilant leadership

Sometimes, management focus more on optimizing their own pay rather than optimizing returns to the shareholders. In other cases, management may have the intention of maximizing the returns to the shareholders, but are taking high risks in doing so.
many managers simply want to grow their “empire” with the shareholders’ retained earnings.

rule 1: low debt

debt-to-equity (D/E) ratio = liabilities/equity
A company’s goal should be the flexibility to enter good projects at all times and withstand any challenges in the market. This is generally achieved when the company sustains a low debt-to-equity ratio of below 0.5
Some industries are characterized by low debt-to-equity ratios; while banks, with a core product of debt, typically have higher ratios. You should therefore also consider industry standard for normal levels of debt.

rule 2: high current ratio

current ratio = current assets/current liabilities
if a company always receives more cash than it pays out, the company can meet its short-term debt obligations at any time (typically current ratio between 1.5 and 2.5)
- a low current ratio may mean that the company has problems meeting their short-term obligations, while higher current ratio may indicate bad money management due to an inability to collect payment from vendors.

rule 3: strong and consistent return on equity

return on equity = net income / shareholders’ equity
in general, you should look for companies that have had a consistent ROE of above 8% over the last 10 years. It tells you that the company is consistently making a decent profit with the earnings that management retains.
look for a ROE that has been steady or even increasing over the last eight to ten years. This means that the company generally keep all or some of the capital for future investment and increases the equity.
check the industry trend for comparison
never be attracted to a high return while compromising security. In other words, manage risk first (i.e., D/E), then consider the remaining choices based on yield (i.e, ROE).
By choosing a company with historical D/E of below 0.5, you will most likely end up with companies with lower ROE, but they will likely be more sustainable in the future.

rule 4: appropriate management incentives

compensation packages based on stock price performance gives management wrong incentives to act truthfully to protect the shareholders’ interest.
trustworthy companies and management teams disclose the structure of the compensation plans.
managers should only be rewarded based on performance and long-term goals. You should look for long-term roadmaps with a variety of objectives to be obtained.

Principle 2: a company must have long-term prospects

value investors try to minimize taxes by owning outstanding businesses that remain stable over a lifetime.

rule 1: persistent products

invest in product that will not change in the next 30 years such as coke where it does not change due to technology.
Warren Buffett’s favorable holding period is forever.

rule 2: minimize tax

let your investment compound and grow for a long period of time before the government gets their share.
short-term capital gains is usually higher than long term capital gain tax

Principle 3: a company must be stable and understandable

stay within your circle of competence to find companies that are stable and you can understand the fundamentals that drive the profit and the company’s competitive edge.

rule 1: stable book value growth from the owner’s earnings

owner’s earnings
it is extremely important to find a company that demonstrates a consistent earnings capacity, book value growth, and a stable and respectable ROE over numerous years, not just a few.
if the company retains earnings (reflected in book value growth), there should be corresponding growth in future earnings (reflected in EPS growth)
stable and understandable stock

rule 2: sustainable competitive advantage (moat)

find business that has sustainable competitive advantage
- higher profitability, higher return on capital, and large market share
the sustainable competitive advantage cannot be duplicated by competitors; hence the business will keep pouring money into the owners’ pockets.
- For example, Coca-Cola has a great moat due to its enormous brand value, share of mind
- Wal-Mart has a wide moat due to its cost structure where it can buy products with large volume from its suppliers at a cheaper price than its competitors.
- Apple has networks effect: the more people join apple community the more profit it made
  - A company enjoys a network effect advantage when the values of it’s product or service increases with the number of users. Network effect companies are often digital. Facebook, Google, eBay and Western Union are prime examples of such companies. Take Facebook as an example. The more users it has, the greater the reach it has with its ads, the more companies are willing to pay for its reach.
- Geico has low cost when price significant to customers
Sample moats from different industries. High cost of switching to Samsung even iphone is more expensive
- intangible assets such as brands and patents
  - Examples of intangible asset advantages include: patents, brand reputation and government licences such as Disney. Tiffany & Co. is a prime example of a company with an excellent brand reputation. The company’s established brand name provides it with significant pricing power: a necklace from Tiffany & Co. could easily costs several thousand more than a necklace from a less well-known brand. Vanguard’s patented technique that avoids taxes on mutual funds has enabled it to charge significantly less management fees for its financial products while preventing incumbents from imitating it. Bond rating agencies are great examples of companies that have a significant regulatory advantage. Ratings agencies must be granted a “Nationally Recognized Statistical Ratings Organization” recognition before they can practice in the United States. This stringent regulatory requirement limits the playing field and allows ratings agencies to enjoy absurd profit margins (Moody’s was 50% according to the book).
- low cost
  - Wal-Mart can buy at quantities and prices that competitors can’t match.
  - Cost advantages can stem from four sources: cheaper processes, better locations, unique assets and greater scale. Process based advantages are often less desirable because other companies might attempt to copy their process. These types of advantages are the most salient in industries where price plays a critical part in the customer’s purchasing decision. According to the author, Southwest Airlines had a process-based cost advantage moat in the airline industry. The company used only one type of jet, minimized ground time and rewarded employee thrift, which allowed them to charge less than their competitors. Southwest was an exception to the generalization that process-based moats are less desirable. Their thrift-centric process was so different from their competitor’s processes that it could not be du
- high switching costs (“stickiness”)
  - most people will not bother with the hassle of changing operating system such as Microsoft, because they do not want to re-learn the new system.
  - Dorsey identifies three main flavours of switching costs — tight integration with a customer’s business, high monetary switching costs and high retraining costs. Oracle and Adobe are two companies in this category of companies. Oracle’s database systems are so heavily ingrained into their client’s businesses that it would be extremely costly for firms to replace them. Furthermore, replacing them could entail unwanted operational risks. Such tight integration with a customer’s business enables high retention rates, steady cash flows from customer annuities and a certain degree of pricing power for Oracle. Most digital designers have spent years mastering Adobe Photoshop. If a design firm were to force its designers to use a different image editing software it would incur a significant financial and timely retraining.
porter 5 forces
- barriers to entry: advantages that existing, established companies have over new entrants. A firm will enter the industry it it forecasts that the potential reward for being in it is greater than the cost of overcoming the barriers and the retaliation that is likely to happen.
  - supply-side economies of scale: spread the fixed costs over a larger volume of units.
  - demand-side benefits of scale: network effect, people tend to value being in a ‘network’ with a larger number of people who use the same company.
  - customer switching costs: airline frequent flyer programs are an example. Customer doesn’t want to switch to different product to avoid re-learning (such as microsoft operating system, or iphone)
  - capital requirements: websites and apps can be launched cheaply and easily as opposed to the brick and mortar industries of the past. Railroads are almost impossible to enter. It takes a ton of capital and it is an enormous risk to build a second railroad network next to to the existing one
  - incumbency advantages independent of size (e.g. customer loyalty and brand equity)
  - unequal access to distribution channels: new entrants may struggle to find a retail or wholesale channel to sell through as existing competitors will have a claim on them
  - governmental policies
- threat of substitutes
  - perceived level of product differentiation: lowest price or differentiation. Developing multiple products for niche markets is one way to mitigate this factor.
  - number of substitute products available in the market, ease of substitution, availability of close substitutes.
  - substitutes that are becoming cheaper relative to performance and substitutes that earn high returns on capital are likely to have more new entries in the future, which will drive prices down within that industry.
  - companies within industry of power grids face pretty much no substitute at all. No matter how the electricity is produced, it must be transported somehow.
  - newspaper face tough competition from online and social media
- bargaining power of customers
  - ability of customers to put the firm under pressure, which also affects the customer’s sensitivity to price changes.
  - RFM (customer value) analysis: how recently did the customer purchase? how often do they purchase, how much do they spend?
- bargaining power of suppliers
  - degree of differentiation of inputs
  - impact of inputs on cost and differentiation
  - presence of substitute inputs
  - strength of distribution channel.
  - supermarkets are powerful players in distributing products of suppliers
- competitive rivalry
  - sustainable competitive advantage through innovation
  - competition between online and offline organizations
  - level of advertising expense
  - lower prices, new products and increased service and common weapons of choice and they l0ead to lower profitability for companies.
  - look for industry with few companies, high growth and low fixed costs

Principle 4: buy at attractive prices

rule 1: keep a wide margin of safety to the intrinsic value

if a margin of safety is 30% on one stock, it may look tempting, but if you have the option to buy another great business (of equal risk) with a 50% discount, you would go for that one instead.

rule 2: low price-earnings ratio

P/E = market price for the company/Net Income
P/E ratio is simply a current snapshot in time. it looks at the company’s present performance in order to determine the value of its future performance. This is often a dangerous path if you fail to consider the other variables
conservative investor looks for stocks with a P/E ratio below 15, or, in other words, the return should at the very least be 6.67% (which is 1/15) annually. She does not buy into hopes and dreams and she does not think she can spot the new Microsoft. Instead, she busy into a company that is already making a decent profit compared to the price she pays.

rule 3: low price to book ratio

price-to-book ratio = market price per share/book value per share
measures how much the investor pays for every $1 of hte company’s equity.
Benjamin Graham would try to find companies that had a P/B ratio of below 1.5 as a threshold for indicating value.

rule 4: set a safe discount rate

FV = PV * (1 + i)ⁿ
- FV : future value
- PV : present value or intrinsic value today
- i : discount rate
- n : number of years
Warren Buffet’s opinion is that no investment should yield a lower return than a federally issued bond because the federal reserve can simply print more money in order to fulfill its interest obligations; therefore, if a ten-year bond has a 3% return, the investor should never discount a ten-year investment decision lower than 3% annually.
we can use a conservative market price to determine the current discount rate or potential rate of return
- i = (FV / PV)^1/n - 1

rule 5: buy undervalued stocks - determining intrinsic value

Warren Buffet says, “Intrinsic value can be defined simply: it is the discounted value of the cash that can be taken out of a business during its remaining life”
every valuation technique can be boiled down to one thing: “How much money can I expect to get in return for my initial investment”

Discount Cash Flow Instrinsic Value Model

DCF Stock valuation
https://www.buffettsbooks.com/how-to-invest-in-stocks/advanced-course/lesson-35/
FCF_n = BYFCF * (1 + GR)ⁿ
DF_n = (1 + DR)ⁿ
DFCF_n = FCF_n / DF_n
DPCF = [BYFCF * (1 + GR)ⁿ⁺¹ * (1 + LGR)] / (DR - LGR) * 1 / (1 + DR)ⁿ⁺¹
intrinsic value per share = intrinsic value / common shares oustanding
- FCF_n: free cash flow for year n
- BYFCF : base year free cash flow (current free cash flow)
- n : number of years into the future, or year being discounted
- GR : company’s estimated annual growth rate
  - a great starting point for picking a percent would be an assessment of the company’s historical free cash flow growth rate. That can be found during your assessment of the company’s previous cash flow statements.
- DF_n: the discount factor during year n
- DR: discount rate
  - the discount rate represents the return you would like to receive for owning the company.
- DFCF_n : discounted free cash flow for year n
- DPCF : discounted perpetuity cash flow
- LGR : long term growth rate
  - for anyone who thinks they’ll be able to predict a company’s ability to grow their profits, beyond the 10 year mark, best of luck
  - is this company going to have the capacity to remain relevant beyond 10 years?
    - if yes, simply using the rate of inflation (2-3%) to protect your estimate from being too optimistic.

buffet intrinsic value model

https://www.buffettsbooks.com/how-to-invest-in-stocks/intermediate-course/lesson-21/
DCF model allowed you to estimate the company’s value by discounting cash flows into perpetuity. The Buffet instrinsic value provide a finite solution and only summed the cash flows for a 10-year period.
DCF model use free cash flow, and Buffetts calculator use dividends plus book value growth.
use the model that provides the most conservative estimate.
limitations
- it only works if a stock fulfills all four of Warren Buffett’s principles.
  - if a company lacks certain aspects of the principles discussed, those aspects should be assessed as additional risk to the investor.
  - these qualitative aspects should be accounted for by lowering the book value growth rate, lowering the dividend rate, requiring a higher discount rate, ore not even evaluating the stock all together.
- high-growth companies
  - high growth companies naturally have a better opportunity to grow their book value compared to large, slow-growth companies, even if it’s for a limited period of time. These growth rates will yield very high intrinsic values in the calculator. Avoid using more than 13-15% for book value growth in the calculator, even if the company has shown much higher growth over the past 10 years.
- high degree of share buy-back
  - buy-backs distort the book value, which in turn also distorts the intrinsic value.
  - if it’s corporate strategy to reduce the number of shares outstanding, you’ll probably want to use the DCF model instead.
- stock splits
  - historical book value growth rate isn’t representative of its actual performance.
  - maybe easier to use the DCF model to avoid the disparity when assessing how much the book value may grow in the future.

rule 6: the right time to sell

when to sell stocks
probably wants to consider the impacts of capital gains and bank fees before you impulsively switch assets. You should revert back to Warren Buffett’s four principles:
- is the company still managed by vigilant leaders
- does the company still have products and services that have long-term prospects?
- are the company’s earnings and debt management still stable and predictable?
- based on the projected cash flows, what kind of return you expect at the current trading price?
maybe you feel that 20% or 35% of your portfolio in one stock is too risky. Although Buffett likes a focused portfolio, he still keesp more than 10 different picks in his portfolio
to decide if you should keep or sell your current holding (stock A), or invest in another (stock B), follow these 4 easy steps:
- calculate the expected annual return for stocks A and B based on the current market prices
- subtract the cost of capital gains tax from stock A
- calculate whether stock A or B yields the highest expected annual return based on a given time frame.
The company has changed for the worse. Perhaps the company’s management has shifted their focus to an area where you believe to drive less growth than you would like.
there’s other investment with better opportunity cost

Quotes

“I find it much easier to think about what should develop over a relatively long period of time than what is likely in any short period. As Ben Graham said: “In the long run, the market is a weighing machine – in the short run, a voting machine.” I have always found it easier to evaluate weights dictated by fundamentals than votes dictated by psychology.”

“My mentor, Ben Graham, used to say: ‘Speculation is neither illegal, immoral nor fattening (financially).‘”

“I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%.”

“I make no attempt to forecast the general market — my efforts are devoted to finding undervalued securities.”

“Just because something is cheap does not mean it is not going to go down.”

“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply because important people agree with you… You will be right, over the course of many transactions, if your hypotheses are correct, your facts are correct, and your reasoning is correct.”

“Short periods of measurement exaggerate chance fluctuations in performance.”

“What I can and do promise is that: Our investments will be chosen on the basis of value, not popularity; that we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments…”

“It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years.”

“Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”

“If a 20% or 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments.”

“…my own investment philosophy has developed around the theory that prophecy reveals far more of the frailties of the prophet than it reveals of the future.”

“The course of the stock market will determine, to a great degree, when we will be right, but the accuracy of our analysis of the company will largely determine whether we will be right. In other words, we tend to concentrate on what should happen, not when it should happen.”

“The availability of a quotation for your business interest (stock) should always be an asset to be utilized if desired. If it gets silly enough in either direction, you take advantage of it. Its availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgments.”

“So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”

“Not a dime of cash has left Berkshire for dividends share repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month.”

“ Our net worth has increased from $48 million to $157 billion during the last four decades. No other corporation has come to building its financial strength in this unrelenting way. By being so cautious in respect to leverage, we penalise our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.”

“Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur.”

“Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value.”

“what we’re looking for: (1) Large purchases, (2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations), (3) Businesses earning good returns on equity while employing little or no debt, (4) Management in place (we can’t supply it), (5) Simple businesses (if there’s lots of technology, we won’t understand it), (6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).”