There are dozens of books written on the topic of value investing, and many even claim to reveal the secrets that made superinvestor Warren Buffett billions of dollars. David Clark and Mary Buffett's bestselling book Buffettology, as the name suggests, belongs to the latter category, but the reason it stands out is that it actually delivers on its promise.

As a value investor, you should always try to buy companies below their intrinsic value, right? Wrong! Well, at least that's not the most important criteria Warren Buffett uses to decide when to buy a stock according to Mary Buffett. Not anymore.

Warren Buffett started out as  a disciple of the famous Benjamin Graham, author of the highly influential books Security Analysis and The Intelligent Investor. Graham aimed to purchase companies for less than they were worth. He called this discount to intrinsic value his margin of safety.

Graham versus Buffett

Graham was an absolute pioneer in the field of value investing, and Warren Buffett soaked up all of his knowledge and started applying this strategy himself. At least, until Buffett's brilliant business partner Charlie Munger convinced him that it is more important to buy a good business than a cheap business.

This is what Charlie Munger had to say in a recent Wall Street Journal article:

"I have to say, Ben Graham had a lot to learn as an investor.  His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.

I think Ben Graham wasn’t nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks [companies with limited potential growth selling at a fraction of what they would be worth in a takeover or liquidation] was a snare and a delusion, and it would never work with the kinds of sums of money we have. You can’t do it with billions of dollars or even many millions of dollars.  But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals – probably the only intellectual — in the investing business at the time."

Charlie Munger

Improving Graham

With the help of Munger, Buffett seriously improved upon Graham. The key realization was that if you only focus on getting something for the cheapest possible price, you will end up with crappy companies in your portfolio which never realize their value, or even worse, see their value decline over time, because many of these cheap companies are cheap for a good reason!

If, on the other hand, you purchase a great company with a durable competitive advantage, what Buffett calls a consumer monopoly, and which is able to consistently compound its returns at above average rates, the price you pay becomes less of an issue, because such a company will see its value steadily increase over time. In Buffett's own words:

"Time is the friend of the wonderful business, the enemy of the mediocre."

Warren Buffett

Where Graham, but also the famous Graham-and-Doddsville investor Walter Schloss, bought cheap companies and lots of them to spread the risk, Buffett prefers a focused portfolio with only a handful of excellent businesses with a competitive advantage and growing value. Owning only great businesses means less diversification is necessary.

So what is the main characteristic of a wonderful business? The book says they are like toll bridges: you have to cross them and it costs you a fee each time. Some examples are credit card companies, Google AdWords, and brand name consumer products shops have to carry, like Coca-Cola.

A different view on value

That's why Buffett does not necessarily look at the discount to intrinsic value, but instead focuses on the so called Annual Compounding Rate of Return. This sounds more difficult than it really is. All this rate tells you is how much you can expect to earn each year by purchasing stocks of a certain company at a certain price.

To figure this out, you'll need to estimate how much a company should realistically be worth five years from now, and such an estimate is only possible if a company has consistent earnings.

"Without some predictability of future earnings, any calculation of a future value is mere speculation, and speculation is an invitation to folly."

Buffettology

For this reason alone it is important to look for great, stable companies. Let's say you estimate, using on several intrinsic value models, that IBM should realistically be worth $300 five years from now. The share price of IBM at the time of writing is $165. So at what rate should your returns have to compound annually from the current price to reach the future value of $300 five years from now?

12.7%to be precise. This 12.7% is your Annual Compounding Rate of Return. In other words, purchasing IBM at the current share price will likely earn you around 12% a year for each of the coming five years, given that your estimate is correct. You can calculate this rate of return using the following formula:

(value 5 years from now / current share price)^(1/5)

However, it might be even more useful to determine your preferred annual return, and then calculate at what price you have to purchase a stock to actually have a chance of earning that return. Let's take our IBM example again, assume a future value of $300, and say you want to earn a 20% annual return. This means you'll should only consider buying IBM at a price of $120 or lower. This is what I call the Max purchase price in my premium Value Spreadsheet, and you can calculate it with the following formula:

value 5 years from now / (1 + your desired return)^5

In our case, $300 / 1.20^5 = $120.

Inflation and Taxes

Besides the profitability and value of a business, Buffettology reveals that inflation and taxes are also two things Buffett takes very seriously.

"If you desire to have a real increase in your purchasing power, then it is necessary that the return on your wealth be at least equal to the effects of inflation and taxation."

Buffettology

In fact, Buffett has been happily exploiting a significant loophole in the United States taxation system to defer the payments of his capital gains taxes. This way he is essentially able to let his tax money work for him by letting it compound until he finally decides to sell his stocks. That's why his favorite holding period is forever. This brilliant maneuver has allowed Buffett to maximize his returns by minimizing the amount of taxes he has to pay.

The book also mentions another very interesting idea: inflation can actually benefit shareholders of companies that have a consumer monopoly working in their favor. How? Well, a company with a consumer monopoly generally produces high rates of return on a small net tangible asset base which it almost never has to replace. Now, replacing assets, like machines which break down, happens at inflated prices, so not having to replace Property, Plant & Equipment means such a company avoids inflation! Sweet.

Other People's Money

But the book reveals even more tactics which hardly any other book about his strategy seems to cover: the importance of OPM, Other People's Money.

In order to earn serious money on the stock market, you need a serious sum of money to start with. Warren Buffett did not have such a sum of money himself, so he decided to use the money of others instead!

The initial way he approached this was to start his own investment partnership. He gathered $105.000 from family and friends and got a healthy 25% fee of all returns above 6%. Later in his career he made the brilliant acquisition of the insurance company GEICO. So why exactly was this so brilliant?

Well, because an insurance company receives monthly payments from the people it ensures, but only has to pay this money out sporadically. In other words, insurance companies are sitting on a pile of idle cash, waiting to be paid out if necessary. This gigantic pile of Other People's Money is called insurance float. Buffett used this float to massively increase the amount of money available for investments, which drastically increased his absolute returns.

Some say that Buffett's success is not just due to the fact that he is a great stock picker, but also because he has been able to finance his investments with cheap money. Other People's Money.

Retained Earnings and Return on Equity

Buffett believes all earnings are his, either through dividend payments or retained earnings, since he is (part) owner of the companies he invests in. According to the authors, Buffett places a tremendous importance on retained earnings, which is the net income which remains after dividends have been paid out, and return on equity (ROE).

It is not difficult to see why, because retained earnings is the money that a company can reinvest into the company for future growth, and the return on equity determines to a large extend the extra income that will be generated from these investments. So the higher the retained earnings and the higher the return on equity, the faster the intrinsic value of a company will grow over time.

In a Forbes article, which the book quotes, Charlie Munger summarized Berkshire Hathaway's strategy as follows:

"The objective is to buy a non-dividend-paying stock that compounds for 30 years at 15% a year and pay only a single tax of 35% at the end of the period. After taxes this works out to a 13.4% annual rate of return."

Charlie Munger

Notice that Buffett and Munger prefer companies which do not pay a dividend. This is because dividends lower retained earnings and therefore limit future growth. A company should only pay a dividend, according to the authors, if it has no better way of allocating the money, for example if a company has grown to the size of Apple (AAPL) and therefore has limited room for growth left.

10 Important Lessons

I could go on forever, since the book is packed with thought-provoking insights, but to keep things neat and orderly, here are the 10 most important lessons I learned from Buffettology:

1. First determine what you want to own, then wait for a good price. The price you pay determines your rate of return.
2. To be able to determine your rate of return, earnings and profitability should not only be above-average, but also predictable.
3. Warren Buffett does not calculate the intrinsic value and then buys at half that price. Instead, he calculates the Expected Annual Compounding Rate of Return, compares it with other available investments, and buys the best one.
4. Only buy a company if it has excellent and consistent business economics, and the Expected Annual Compounding Rate of Return is 15% or higher, then hold on to the stock for as long as possible to maximize compounding.
5. Compounding is the #1 secret to getting really rich -> Compound long and hard, with minimum taxes and fees. So limit your number of transactions.
6. Prefer to hold on to a great business with a predictable, consistent 20% return over a quick 35% gain, because the former is hard to find and selling means you have to pay taxes. This could mean you have to hold on to stocks which are trading above their intrinsic value.
7. Consumer monopolies, or sustainable competitive advantages, are the key to long-term, consistent, above-average returns on the stock market. Test: "If you had access to billions of dollars and the five best managers in the world, could you launch a company to compete with the business in question?" No = good.
8. Dividends only make sense if the company has low returns on equity or only minor growth prospects. Share buybacks only make sense if they happen at prices lower than intrinsic value. Acquisitions only make sense if the acquired company is also an excellent business.
9. Excellent businesses are often industry leaders and tend to have low debt levels, large cash flows, a strong brand name, low maintenance & running costs, high quality products & services, an increasing book value, strong earnings, shareholder-friendly management, and a consumer monopoly.
10. Other People's Money is the only way to become ridiculously rich from investing. The books states that "in order to become a billionaire you have to get other people to give you their money to invest."

We covered a lot of ground in this article and I hope you learned a thing or two from it. If you are interested in learning more about Warren Buffett's approach to investing, then enter your name and email address in the form below to subscribe for my weekly investment newsletter, which includes exclusive content which can't be found anywhere on the blog. As a welcome gift, you'll receive my popular eBook The 10 Best Investors in the World as well as three automated investment spreadsheets. I hope to see you on the inside! 

Written by

Nick Kraakman

I'm a value investing expert, serial entrepreneur, and educator. For over 10 years I've been studying the strategies of the world's best investors, and in 2013 I started this website to help other investors consistently grow their wealth. I've already trained 20.000+ people through my best-selling investing course.
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