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Course 507
Great Investors: Warren Buffett

Introduction

The Warren Buffett style of investing teaches that stock-picking isn't rocket science. Buffett, arguably one of the greatest and most revered stock-pickers of all time, says investors shouldn't complicate things by seeking out complicated companies. Stick with what you understand, says Buffett, and choose investments with which you are most comfortable. Here’s what Buffett looks for in an investment.

Easy to Understand Businesses

Buffett has kept his esteemed investment company, Berkshire Hathaway BRK.B, away from fast-growing, high-returning technology stocks such as Microsoft MSFT. Buffett admits that he just doesn’t understand technology well, so he’s content to let others make money there. And before investing in a business, he would prefer to determine what the company will look like 10 years in the future, but technology changes too fast to look that far ahead with any confidence.

High ROEs

Buffett emphasizes return on equity (ROE), the most common measure of a company's profitability. Buffet likes companies whose ROEs he can forecast at least 10 years out. He is particularly fond of firms that don't require a lot of capital to produce a high ROE, which is what drew him to Washington Post WPO. The Post's ROE rarely fell below 15% (twice that of the average publisher) in the 1990s. The Post's superior ROEs stem largely from the fact that newspapers are cheap to produce but can command a lot for ads.

Consistently Strong Free Cash Flows

Buffett is also a stickler for free cash flows, or the money that a company has left over after it has paid the bills and invested in its growth. This "mad money" is one of the main ways in which stock-pickers gauge a company's financial health. TCA Cable, for instance, was not the typical Buffett stock when he bought it in 1999, because at the time the stock was very expensive. Nonetheless, TCA had a brief stint as a Berkshire holding (before it was acquired by Cox Communications COX later that year) because Buffett liked TCA's free cash flows--$131 million in fiscal 1998. Consistently strong free cash flows mean that a company is generating real cash for its owners.

Limited Debt

In the 1990s, Buffett bought insurers Geico and General Re (the latter for $17 billion) because he liked that the companies kept a handle on debt. More than that, however, Buffett likes the "float" that insurance companies offer. (The float is money collected as premiums but not yet paid out as claims.) In March 1999, Buffett enjoyed a float of nearly $23 billion. Until policyholders collect on their policies, Berkshire can invest those billions as it sees fit, and who better to invest that money than Buffett himself?

Quality Management

Among the most notable aspects of Buffett’s stock-picking prowess is that he looks for quality in the company itself and the people running it. When Berkshire buys a business, it buys the management as well. Buffett and longtime Berkshire colleague Charlie Munger try to assess whether a company's top executives love the business or the money. They look for people who love the business first. Buffett says they don't tinker with how top brass runs the company as long as the business is successful. In light of Buffett's blatant avoidance of high-flying technology stocks, his stock-picking method is not necessarily for everyone, as he would be the first to admit. (That's just his modesty talking, because Berkshire has made millionaires out of thousands of everyday citizens.) Each investor's goals and areas of expertise are different. Those who choose to follow Buffett's school of thought, however, can rest assured that the basic principles of his style of stock-picking are based mainly on common sense: Concentrate on what you know best, and look for quality companies.

Quiz 507
There is only one correct answer to each question.

1 According to Buffett, what's the best approach to investing?
a. Choose companies that offer great returns, even if you're not familiar with them.
b. Seek out companies that are in the news.
c. Stick with what you know and choose investments with which you are most comfortable.
2 Buffet likes companies with high returns on equity (ROEs), but what does he like even better?
a. Companies with high ROEs that are also high in price.
b. Companies that don't require a lot of capital to produce a high ROE.
c. He doesn't look for qualities beyond a high ROE.
3 Why in 1999 was Buffett drawn to a pricey stock like TCA Cable (now part of Cox Communications)?
a. It had strong free cash flows.
b. It was cheap relative to other cable stocks.
c. Buffett's best friend ran the company.
4 What is the name of Buffett's investment company?
a. Berkshire Hathaway.
b. Berkshire Holdings.
c. Berkstein Group Inc.
5 Which is <em>not</em> a quality Buffett looks for in a company?
a. Good management.
b. Limited debt.
c. Earnings growth in excess of 20% per year.
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