The Enigma of Warren Buffett

The greatest investor of all time has granted British university students an audience in 2009.

Who is Warren Buffett?

Put simply, he is a proven compounding machine the likes of which has yet to be reproduced in the world. If you had invested $1,000 with Warren Buffett in 1956 (circa. $7,760 in 2008 dollars), it would be worth about $30.6 million today, give or take a little due the uncertain inflationary/deflationary times we live in. Compare this to the $140,000 that would have been generated by the DOW/S&P and you begin to understand the magnitude of his achievement. To what purpose has this all been? Buffett has allocated most of his wealth to the Gates foundation, in the largest single act of philanthropy ever seen.

Where did he come from?

The son of a politician/stockbroker, Buffett grew up in Omaha and Nebraska and was schooled in Washington, DC . Similar to a certain Mr Branson (also the son of a stockbroker), he was interested in business from a young age having set up several successful enterprises while in his teens. Unlike Mr Branson, Buffett was a child prodigy going to college at Wharton, graduating from the University of Nebraska and completing graduate school at Columbia (much to the chagrin of Harvard Business School who rejected him) at a much younger age than expected. At Columbia he met his academic father Benjamin Graham, one of the strongest advocates of value investing. Working initially as a stockbroker at his father's firm, Buffett eventually secured employment in Graham's New York investment partnership.

Following the closure of Graham's partnership, he set up on his own in Omaha using savings and investor capital from local doctors, friends and family. (It is interesting to note that Buffett didn't take a management fee, but rather took a share of the profits - fund managers could learn a lesson here). This is when the compounding machine started working for itself in earnest. Along the way he picked up Berkshire Hathaway - a textile mill that he transformed into the holding company that it is today. It is his shares in this cash fountain that makes him the richest person in the world.

How did he do it?

Broadly speaking, Buffett's investment philosophy has relied on extreme caution in capital preservation and investing only in solid cash generating businesses expressed through a few themes. That, and a substantial amount of luck.

Buffett comes from the "Graham and Doddsville" school of investing (Dodd was the other Columbia Professor who taught security analysis). This approach takes the view that the only stock worth investing in are those having a higher book value than market capitalisation, i.e. the net worth of the firm is greater than the value it trades at. Beginning with this method, Buffett relaxed his terms when considering undervalued firms that had superior management. He never overpaid for a company though, waiting for weaknesses in markets to make significant purchases. Taking a controlling interest in firms, he pushed to raise prices and cut costs. Once a business was producing strong cashflows in a saturated industry say, Buffett used these profits to acquire interests in other undervalued firms with strong cashflows and good future prospects. He also courted those in the limelight and through his Washington Post connections, where he held a stake, he would have been able to learn of many investment opportunities ahead of most investors.

He invested in businesses that took upfront payment from customers and paid back a proportion of revenue over time as a goodwill gesture. (The usual business assumption is that cost of sales must be paid before revenues are generated.) Thus with a continual stream of customers, there is guaranteed to be a 'float' of cash. He invested this float in yet more businesses. Starting with coupon collecting companies, Buffett bought controlling stakes in insurance companies and applied the same "get paid to borrow money and invest" method to increase the value of his holdings.

In the early 90s, Buffett came up against issues of size. His investments had grown so large that he was struggling to find opportunities even when markets had fallen. More importantly, Berkshire Hathaway had been noticed. Disclosures of its holdings would push prices higher against Buffett. Keen to continue his stellar returns, he invested in privately held companies, often buying family businesses from founding entrepreneurs approaching retirement. One sentimental example is that of Rose Blumkin's furniture mart, owned by a Russian émigré speaking no English who built up a firm with sales of $50 million. When she was 93 she sold the business to Buffett, retiring from managing at age 102.

In the late 90s Buffett was criticised as having missed the opportunities in technology stocks because of his aversion to investing in any business that he can't understand. (Buffett is a genuine luddite: not able to use a computer until very recently, despite being good friends with Bill Gates). However, the dot com bubble burst in 2001 and vindicated Buffett's conservative investment approach. Yet there were missed opportunities too; Buffett famously held back from investing in Intel at its inception, an investment that would have propelled him even further as an unparalleled investor.

There is a caveat from his usual defensive investment approach. At times, Buffett invests in high-yielding convertible debt. Using his reputation, he has been able to dictate favourable terms when purchasing corporate debt of high profile companies. The companies benefit by having Buffett endorse them and the confidence this gives other creditors and stockholders. Notably, such stakes have been in financial firms such as Solomon Brothers and more recently Goldman Sachs and General Electric.

Buffett has also been bearish towards the dollar, viewing the current account deficit as eventually leading to dollar weakness. Expressing this indirectly, Buffett has been investing in companies generating revenue in currencies other than the greenback. In all the recent credit crunch turmoil, he has started buying again, seeing substantial opportunities in US equities.

Why is he able to consistently outperform the market?

It is curious that despite starting from higher capital bases, no other investor has been able to emulate returns to Buffettesque levels. Why have others have failed to do what the Efficient Market Hypothesis (EMH) deigns impossible and Buffett has demonstrably shown to be a very human feat?

At the heart of Buffett's philosophy is the belief that markets will fluctuate over a short run period and push asset prices above and below their 'fundamental' value, but over the long run markets will have to recognise the true value of a business. Applying this thinking, Buffett is a contrarian: He buys greedily when others are fearful and is fearful with investments when others are greedy.

One less considered fact is that Buffett genuinely enjoys evaluating and investing in businesses; following the markets religiously and actively thinking about possible outcomes, investing only when mostly likely to yield reasonable profits, while almost always minimising the risk of losing initial investment. Consider how many analysts would take research reports with them on their honeymoon and use the route as an excuse to meet with CEOs. No, I'm not kidding!

Finally, Buffett's reputation, exemplary, affords him a discount when purchasing private businesses; knowing that he will ensure the longevity and profitability of any concern that comes under his remit gives entrepreneurs comfort when negotiating price.

Will we see another Buffett?

Blogs and economists suggest not. Markets are more efficient, they say; there are stricter investing regulations; his style of investing belongs to bygone era. If any further evidence of his fallability in current times is needed, critics point to recent results which have seen profits fall for four straight quarters, precipitated by bad underwriting and significant exposure to businesses that have seen profits fall as a result of the credit crunch.

Nonetheless, many are trying to apply the Graham and Doddsville approach to investing. Some successors to his crown are even being suggested (Eddie Lampert is a name that crops up regularly), but their performance has to be validated for the many years that Buffett has managed to perform. Perhaps they can, let's see. In the meantime the gentleman from Omaha, who tap dances to work everyday will continue to enthral and defy the markets. Take that EMH!

Ravi is a Third year DPhil Student in Statistical Finance. He is Graduate Officer for the Oxford Investment and Finance Society and has a weekly radio show discussing themes in financial markets and the investment community.