- The authors outline the principles and rules of value investing, which are guiding principles that’ll aid the analyst in finding ‘Buffett-type businesses’ and having the mentality necessary to buy, hold and sell when Mr. Market is on your side.
I owe quite a lot to the authors of this book, Preston Pysh and Stig Brodersen. The video courses on their website, www.buffettsbooks.com, helped me immensely when I first began diving into the value investing philosophy. Quickly thereafter I became rather addicted to their podcast The Investors Podcast. To pick up Warren Buffett Accounting Book was thus long overdue!
The extra mile
Before I’ll dive into what I believe is the crux of the book, let me highlight a couple of quotes I found quite profound. The book starts out by discussing how you can profit from intelligent investing in the stock market. First, Preston and Stig underscore that investing is a long-term game, but that few have that attitude: “Most people would rather rely on the promise of getting rich tomorrow than the certainty of getting rich in twenty or thirty years.” (p. 13)
If you combine a long-term view with the willingness to put some effort into learning how to read financial statements, analyse businesses and learning how to calculate intrinsic value, you got a real shot of being a succesful stock picker: “You have decided to go the extra mile and study these concepts. And guess what? There are seldom traffic jams on the extra mile.” (p. 15)
Alright, so are you pumped to learn “these concepts”? Let’s get to it!
The Principles and Rules of Value Investing
Other than teaching the readers how to read the income statement, the balance sheet and cash flow statement, you’ll learn the principles and rules of value investing. These, I believe, are meant to be guiding principles that’ll aid you in finding ‘Buffett-type businesses’ and having the mentality necessary to buy, hold and sell when Mr. Market is on your side.
Principle 1 – Vigilant leadership: Preston and Stig have identified four rules that are good indicators of “vigilant leadership”.
The first of which is to look for conservatively financed companies. Debt disrupts a business by limiting its flexibility and agility. A neat metric to look for stocks that aren’t heavily burdened by debt is to look at the debt-to-equity ratio (D/E). As a rule of thumb, one should prefer stocks with a D/E ratio of below 0.5.
To narrow the field even further, the authors advise the readers to look for a current ratio of >1.5, which constitutes rule no. 2. In short, a high current ratio means the company got more cash coming in than out. In ‘balance sheet’-terms it implies that the company has at least 50% (1.5) more in current assets than current liabilities.
Rule no. 3, strong and consistent return on equity (at least 8%) over a period of 10 years, is a signal that management is able to compound the shareholders’ capital.
The fourth and final rule is to look for businesses that have appropriate management incentives. The management’s “one and only” task is to create shareholder value. Make sure management’s interests are aligned with yours, i.e. stock options based on creating long-term shareholder value.
Principle 2 – Long-term prospects: In length of principle 1’s underscoring of long-term shareholder value, Preston and Stig emphasize that the businesses you buy stocks in should have a positive long-term outlook. Two rules help guide the analyst in determining just that.
Rule no. 1: There should be a persistent demand for the business’ products/services. Acquiring stocks in businesses that offer products, which never go obsolete, allows the investor to hold said stocks “forever” – right up Warren’s alley! To recycle a paragraph from my book summary of Charlie Munger: The Complete Investor: “It’s much better to buy and forever hold great companies with outstanding economics and expanding values because then “you can sit on your ass [and] that’s a good thing.”
The second rule is much simpler: minimize taxes. Especially in the US, the capital gains tax system is the friend of the long-term investor. But in general, it’s always a good idea to keep the tax man at bay by letting your investment grow and compound for long periods of time before letting the government take its share.
Principle 3 – Stable and understandable: It’s well-known that Warren fancies simplicity, and it hasn’t slipped past Preston and Stig either. Again, only two rules are necessary to drive home this point.
“A stable and understandable company is the basis for minimizing risk and setting expectations for potential performance.” (p. 69) It’s well put, and very much in line with Warren and Charlie’s mantra that if an idea is too difficult there’s no shame in putting it in the “too hard”-pile. Products that don’t change with the internet and technology are the basis of a simple business, and remember: simple is good! Rule 1 is a way to evaluate whether the business surely is stable: look for business with stable book value growth derived from the owner’s earnings. The authors put it as such: “If the company retains earnings (reflected in book value growth), there should be a corresponding growth in future earnings (reflected in EPS growth).” (p. 68)
Arh, moats, the essence of Buffettology. Sure enough, the authors made sure to create a rule based on this concept: “By only investing in companies with a durable competitive advantage, you also reduce long term risk. A moat can come in the form of intangibles, low-cost structures, and high switching costs (or stickiness).” (p. 72) In short, a stable business is one with a clearly identifiable and understandable moat that is durable for years and years to come.
Principle 4 – Attractive purchase prices: Allright guys, I’ve probably dwelled on this enough in various other posts, i.e. What is value investing? and the Lessons from 20 investment books post series (part I, II and III). So, I’ll run through the authors’ 6 rules rather quickly, but make no mistake, these are important!
- Keep a wide margin of safety to intrinsic value.
- As a rule of thumb, a P/E below 15 is often a good starting point in finding undervalued stocks.
- As a rule of thumb, a P/BV below 1.5 is often a good starting point in finding undervalued stocks. However, a strong moat can justify paying a premium to book value.
- Apply a discount rate that is considered “safe”, i.e. one above the zero-risk investment rate (e.g. the yield on T-Bills/short-term government bonds) plus a premium that translates into a conservative estimate of intrinsic value (read more on calculating intrinsic value and discount rates in How much is LEGO worth?).
- Buy undervalued stocks.
- You should sell a stock 1) when the company is breaking one or more of these four principles, 2) it takes up too much of your portfolio, or 3) you can get a better return from other investments.
If you’re looking for a great ‘starter book’ on reading annual reports, getting familiar with the value investing philosophy, analyzing businesses and estimate intrinsic value, look no further!