Sunday, November 30, 2003

Book Review!

I just finished a great book: "Buffett: The Making of an American Capitalist" by Roger Lowenstein. I had been wanting to read a book about Warren Buffett for some time, and this book has to be the most interesting biography I've ever read. (well, OK, it was more interesting than "A Beautiful Mind" so of the 2 biographies I've read, the one about Buffett was more interesting).

For those who haven't heard of Buffett, he's currently the 2nd richest man in America (the richest being Bill Gates One of the cool things about Buffett is that (unlike every other person you see in the top 10) he made his money by investing the stock market. The majority of the "richest people" lists are people who have made billions on a single great idea (Microsoft, Dell, Oracle, Wal-Mart). He never added any additional capital to his portfolio- he only reinvested the profits his investments made. On average, his portfolio has returned 23% annually, as compared to a historic average of around 10% for the S&P 500.

Most Buffett book reviews grab the reader's attention by saying that $10,000 invested with Buffett in 1956 would be worth more than $200 million today. While that's true (and astonishing) consider that $10,000 invested in a simple S&P 500 tracker (at 10%) for the same period would be worth $970,000 today. While $200 million vs. $970,000 is indeed impressive (when in my mind 23% isn't THAT much better a return than 10%), we're once again reminded of the power of compound interest. Note to self: "Invest early in life, and divert as much of your income as you can stomach into investments."

Buffett is quite a character. He still lives in the same humble home in Omaha that he did 40 years ago. Some mistake him for a bumpkin (as they did when he was "missing the boat" during the dot com run-up, and previously during the "go-go" market days prior) only to be proven very wrong as Buffett's laser focus on value sees stocks back in line with their "intrinsic value". Evaluating stocks based on their intrinsic values is Buffett's "secret". Here's an excerpt from Buffett's "Owner's Manual" on how to measure intrinsic value:

"You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education's cost as its "book value." If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job.

For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.

Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value."

Bam: while reading this book it hit me. So many things became clear to me that were previously muddy. Investing- and by that I mean NOT ONLY investing ones money in the stock market or in interest bearing accounts in an effort to save for the future- should always be guided by rate of return. When you consider doing something in life for financial gain, always measure it in the sensible terms that Buffett lays out. What I took this to mean from the book:

1) What's the initial investment?
2) What's the margin?
3) How long will it take to pay back your initial investment?

Say for example that I want to own a Subway Sandwich Shop (I actually have thought about this). To start a Subway up costs roughly $100,000. Most Subways bring in about $25,000 a month, with their margin being about 20%-30% giving them a monthly profit of say $5,000. Using this metric, if I own 1 Subway, it'll take me about 2 years to pay back my initial investment, and each Subway will give me an annual income of $60,000. I encourage you to apply these same simple concepts to a business idea that you may have- how does it look?

This book does not have a textbook feel to it. It was a very entertaining, fast read. BUT, I learned more about common sense investment analysis that stuck in my mind than I learned in half a dozen MBA classes on investing.

The story focuses on Buffett's folksky, down-to-earth manner, and how he got to where he is today. Reading the book, I thought I was reading about an icon whose time had come and gone. Until I went to the Berkshire Hathaway web site. There, I see that he is still very active, running a company that is really nothing more than a holding place for his various investments. You'd be surprised at the stocks and companies he owns. The Pampered Chef. Coca-Cola. Gillette. American Express.

Buffett doesn't believe in stock splits because they DO NOT create wealth for anybody. They only cut the pizza pie into more slices- the pizza doesn't get any larger. Consequently, shares of Berkshire Hathaway that once traded for around $8 are now worth $80,000! Have no fear though. Class B shares of Berkshire are now available at the bargain price of $2800 (as of this writing). Have a look and buy some if you don't want to bother learning Buffett's method and would prefer to just ride his coat tails: Yahoo! Berkshire Hathaway Quote.


Check this book out at
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