Strategy Review: Robert Hagstrom’s The Warren Buffett Way
September 17, 2007 | Joe Ponzio | about: JNJ
Back on August 4, 2007, I promised Michael that I would look at the Quicken site and revisit Robert Hagstrom’s investment strategies outlined in The Warren Buffett Way. Then, I completely forgot to do so. Sorry Michael-better late than never, right?
If you are not familiar with Hagstrom, he is the portfolio manager of the Legg Mason Growth Trust mutual fund and author of several books: The Warren Buffett Way, The Essential Buffett, and The Warren Buffett Portfolio, among others. The Warren Buffett Way presents a myriad of strategies for valuing companies…and that is precisely this book’s weakness.
Determine The Value
Hagstrom picks apart some of Buffett’s larger, more permanent holdings and presents certain valuations and rationale for buying. The problem is that there is no consistency in the valuation methods. Now I admit: There’s more than one way to skin a cat (or value a business), but it all comes down to one simple tenet-the value of a business is the discounted value of the cash that can be taken out of a business during its remaining life.
Owner Earnings = Net Income?
When analyzing Buffett’s purchase of The Washington Post Company, Hagstrom calculates owner earnings as net income-Wall Street earnings. Though Buffett does tell us that, over time, depreciation and amortization will equal capital expenditures, the two can vary widely for long periods of time.
Consider this: A company spends $10,000 on a piece of equipment that it will use for ten years. The IRS allows the company to depreciate that equipment for ten years. In that case, the company will have ten years of depreciation at $1,000-or $10,000 total.
Sure, depreciation and amortization will equal capital expenditures, but our company still had to shell out $10,000 today. If it continued to add $10,000 equipment every year, our depreciation would increase…but we’re still spending gobs of money on equipment.
The long and short of it: Owner Earnings do not equal Net Income.
The Post
Hagstrom then goes on to say that Buffett calculated the value of Washington Post to be Net Income divided by the rate of the U.S. Treasury-6.81% at the time-giving the company a value of $150 million. But Buffett himself said most people would value the company between $400 and $500 million. Time to fudge the numbers to make the formula work.
A couple of quick assumptions about profit margins and growth rates, and Hagstrom’s method shows the company to be worth $485 million. Of course, we have to make assumptions about the future to find the value in a company; still, the problem here is the method.
Dividing Net Income By The Treasury Rate
I was messing around in Excel, trying to figure out the logic of valuing a business by dividing owner earnings (or Net Income in this case) by a discount rate to value an investment. Here’s what I found when simplifying the numbers:
Let’s say I offered you a stream of income-$1,000 a year for 100 years. Let’s further say that you wanted to earn 8% on your money. How much is that income stream worth today? Roughly $1,000 divided by 8%-or $12,500.
Translating That To Businesses
If your company generated $1,000 in owner earnings, and you knew that you could rely on that $1,000 for the next 100 years, you could essentially divide $1,000 by your discount rate to find the value of the business. How practical is that?
Well, not practical at all. First, there is no way to know if your company will be around in 100 years. Second, there is no way to predict, with any degree of certainty, what owner earnings will be in 100 years. Third, if your business closes before 100 years have passed, you will have overpaid.
Strategy Changes
The above valuation is not the only method Hagstrom uses. Throughout the book, he presents three of four varying methods using different assumptions. Why? I can only guess that he presents a method for which the numbers work. That is, he looked at the purchase price and worked back from there.
Final Opinion: The Warren Buffett Way
In the end, the book is a good review of the businesses Buffett bought if you ignore the valuations that Hagstrom derived. Does it need to be on your shelf? It wouldn’t hurt. Still, if you are only going to buy a few investment books in your life, I think you can pass on this one.
Final Opinion: Quicken Stock Analyzer
Using Hagstrom’s method, Quicken shows that Buffett would have no interest in Johnson & Johnson. That may comes as a surprise to Buffett and his $3 billion investment.
Filed under: Miscellaneous
Related Stocks: JNJ
I read Buffettology but am revisiting it this week. I am going to try and review some of the top Buffett books to discuss which ones (in my opinion) are “Buffett-esque” and which ones use the Buffett name to sell books.
I haven’t read The New Buffettology – though I suspect (or hope) it is similar to the original. “Hope” because I am fairly certain that Buffett hasn’t really changed his investment strategy since the original Buffettology.
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At times, he uses a modified version of John Burr Williams’ DCF model. Other times, he simply divides net income by the thirty year US treasury rate. In The Warren Buffett Way, he seems to use three or four different models for valuation.
There is more than one way to value a business. Still, I think he made some serious stretches and assumptions to make his valuations work for the book rather than find a model that works for all purchases.
Though I can’t be sure, I assume that Buffett has one simple model that he uses for all businesses. I can’t imagine that he sits at his desk and says,
Well, it didn’t work when I did it this way. Let me try another method and see if the business is undervalued.
My two cents on it.
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At first glance, it might appear so. But… Hagstrom seems to ignore all of the business’ assets. Instead, he values The Coca-Cola Company as the sum of its future cash, but ignores the assets of the business. Here’s a comment regarding ignoring the business’ assets and why, as a business owner or buyer, you shouldn’t (or wouldn’t).
Here’s the other problem I have with it: Using his “residual value” formula would give you the present value of 100 years of income. If you actually run the numbers for years 11-20, using Hagstrom’s 5% growth rate and 9% discount rate, you’d have a residual value of $38,458 (he has $87,900). The present value of that would be $10,072 (he has residual present value of $37,129).
In the end, his formula came up with a value and a margin of safety. Still, I don’t think it is practical (and I doubt that Buffett tries) to estimate the 100-year future value of a company – especially considering few companies ever hit the 100-year mark.
Make sense?
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Joe,
I just finished reading Buffettology. The topics and ideas were portrayed quite clearly. Was a quick read too. Now I am about to go through it again with tooth and comb (my way of deciphering) to try and plug holes in the methods.
Would love read your thoughts on the book.
I use value line investment survey (get it for free from the Library at college) as a screen to select companies and for past data.
what are your thoughts on value line?
Giggsy : “United is Life”
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Hi Joe,
Would you consider making one of your blog posts a list of must-read books about value investing and maybe a short review/opinion of them? There’s a lot of material out there and I’d like to be able to concentrate on the best books available. The only one I KNOW is a must-read is Intelligent Investor.
Thanks,
Ryan
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Personally I think Buffett is such a masterful investor that he can just sense which ones have a high probability of earning a higher return than average and doesn’t necessarily bother with advanced analytical techniques beyond confirming that balance sheets and income statements are strong. He finds investments with positive expected returns, but very low chances of loss. He bases his choices on industry economics, but most importantly, the companies’ competitive advantages… notice he picks individual companies, not industries, because the first rule of economics is that profits are always under constant pressure and long-run excess rates of return tend towards 0.
I think if he did use a formula, it would have to be the residual income (abnormal earnings) model, simply because it emphasizes the fundamentals he looks at (ROE, book value, and growth) and is (to me at least) more intuitive than DCF (which I realize given the same numbers should give the same results since both models are (for long projections) re-arrangements of each other). Valuing a company as a premium or discount to book value greatly simplifies things, as compared to trying to figure out what growth rate and what time frame for that growth a given P/E value assumes. Plus this model shows the margin of safety plain as day (well better than any P/E ratio could). The best part is, you don’t have to forecast 100 years into the future to get a decent valuation… if you assume growth for only a 3 years into the future, you know what the value of your company is based on those 3 years and what book value is now. You can assume normal earnings from then to eternity, or assume the company liquidates. Either way, you will earn about what your RI model predicts. If nothing else, it is a good way to avoid overpaying.
Warren only likes companies to pay dividends when they cannot earn a rate of return higher than what shareholders could earn elsewhere (in his shareholder letters he always says something like “our goal as usual is to ensure that every dollar of retained earnings translates into MORE than one dollar in value”). So that would rule out the common (and useless) dividend growth model. As already demonstrated, to value a company paying all earnings out every year as dividends (just like a bond would), you need only the discount rate and the expected constant earnings. Buffett figured the Washington Post would grow, so he knew his estimate using this method would be low… he knew there was a great margin of safety then and he would earn more than the required rate.
Now, in his earlier years, he was quite successful at using Graham’s method (getting one last puff out of “cigar butt” stocks he says), and that worked quite well. Good luck finding such opportunities these days as markets have become fiercely competitive and arbitrage opportunities should be scarce. If you want to see Graham’s teachings though to get an idea of where Buffett started in the stock picking game and what formed his foundation, read Security Analysis. Fundamental analysis (and there are no secrets to it) is the first thing one should learn.
Finally, I should mention that I don’t think Warren has said much of anything about the books that have been written about his methods, but Charlie Munger did give the nod to The Warren Buffett Portfolio as one that most closely fits their investing style (focus investing of course).
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Buffett uses the DCF method loosely but with Owner Earnings instead of the dividend. However, Charlie Munger said that he has never seen Buffett actually write down and calculate a DCF calculation for a company. Buffett responded with ‘if you have to do that the company isn’t cheap enough’.
I’m a big fan of the Warren Buffett Way actually. Each to their own though. :O)
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Coincidentally, I picked up a copy of “The New Buffettology” at the library on Saturday (along with a Michael Connelly crime novel), but I haven’t opened it yet. FWIW (little ?), one of the co-authors is Mary Buffett, WEB’s ex-daughter-in-law, who also co-wrote “Buffettology”. Have you read either? If you have, any thoughts, comments, etc.?
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