Strategy Review: Buffettology

September 26, 2007 by Joe Ponzio

A few visitors have asked me to review Mary Buffett & David Clark’s Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett The World’s Most Famous Investor. It had been years since I read it-eight, in fact. So, I had to take a day to revisit it (hence no post yesterday).

Buffettology was one of the first “Buffett” books I had read, and I loved it from the very first page. And who could argue the logic provided by someone who sat at the dinner table with Mr. Buffett for the better part of twelve years? I mean, of course, other than me…

Back In The Day

When I first read Buffettology, I was a diligent student-highlighter in hand, hanging on every word. Up until that point, I was playing in options, following charts and trends, and trying to figure out the logic and math to the hourly and daily swings of the stock market. I was convinced that there was a system to beating the markets-I just didn’t know that Warren Buffett had figured it out forty years earlier.

One concept that continued to ring in my head-and was constantly highlighted in my book-was:

“The price you pay determines your rate of return.”

It was obvious. It was simple. It made sense. Why was I just learning it?

The Strategy

The Buffettology strategy is simple: Use past earnings per share to predict future earnings per share, slap on a P/E ratio, and you’ll know the future price. Then, discount that price to today and you’ll know what to pay for your stock. In fact, it is very similar to Phil Town’s method in Rule #1.

Buffettology also spends some time discussing important concepts like: how to identify great companies, diversification, and taxes, among others.

Then, I Read More and Ran A Business

Where is the best place to learn about Warren Buffett’s strategies and beliefs? How about we go straight to the horse’s mouth? I started reading everything he wrote, studying everything on the Berkshire Hathaway site, watching every video and presentation, and analyzing every book I could find or that he would discuss.

I also went into business-both my own and with other people. At times, I ran the daily operations. At times, I sat back and judged the business from afar.

And then it all made sense.

The Long Preface To…

I revisited Buffettology yesterday, and I noticed some very important things were missing from the book. Simple concepts that matter in business and that Buffett has repeatedly told us to look at. For example, owner earnings are never mentioned in Buffettology.

Intrinsic value? Warren tells us:

The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

Buffettlogy tells us:

To Warren the intrinsic value of an investment is the projected annual compounding rate of return the investment will produce.

Two Definitions: Which One Do We Trust?

Here’s the difference in the two: Warren Buffett defines intrinsic value as the amount of cash that can be taken out of a business whereas Mary Buffett defines it as the amount of cash that can be made on a business’ stock.

If Buffett’s method came down to earnings per share and P/E ratios, he would never be able to buy so many private businesses because he wouldn’t be able to determine the intrinsic value of the business. He’d be stuck playing in stocks.

The Summary

Buffettology is a nice primer to the mind of Warren Buffett-if you can ignore the “valuation” methods. In the end, however, it is a book about picking stocks-a book with a great title and great marketing. Any strategy based on earnings-a strategy that might have led you into Enron, Worldcom, Lucent, or a dozen other bad businesses hidden by great stock ratios and wonderful IRS earnings-is a dangerous, gambling, trading strategy.

A Note From Joe Ponzio

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